A (3:16)

So Reinhard, can you build on that? What kinds of changes are we seeing in banking distribution?

C (3:21)

But what we have seen is actually Two things. So one thing is that a lot of the distribution is actually not advisory driven, but can be digitized quickly and actually can be done at scale. So that means banks should always try to get the advisory angle in there or be really, really good in a non advisory driven distribution. And they also need to think about what's happening to it. Some of our estimates believe that we will see up to 30% of distribution in retail banking going via third parties. This could be an online comparison platform, this could be embedded finance. This can happen with the banks or against the banks, where you still only provide the service, but someone else effectively has a customer access and think very, very clearly where they want to position themselves. And for some the answer may be, well, we provide the service at scale and we're still going to have a healthy economic return.

A (4:10)

What kinds of risks are banks facing now in the midst of this great transition?

B (4:15)

The changes in interest rate and then the wide dispersion of economic outcomes and forecast are extremely large. And so these financial institutions, banks need to up their game to the next level to meet these changing risks. And whether that's new regulatory requirements, the macro context risk associated with technology and cyber, that is a critical thing for them to manage right now.

C (4:42)

It's probably one of the toughest question we are asking in the reports. And of course if we forward looking, you have the traditional banking risk about credit risk, about market risk, about liquidity risk, and it's still at the forefront of everyone's mind giving the macroeconomic outlook given geopolitical instability. But you have to actually go further. On the one hand you of course see under the great header of technology risk, cyber risk fraud, we're seeing instant payment being more relevant. We are seeing broader APIs and APIs in a sense that we have broader connectivity to other players, your customers, which introduce potentially additional risk. So that set of things is just simply more complex and needs new skills. And then last but not least is of course the more you interact in ecosystem, the more you interact in partnerships is of course that sometimes the risk may not actually come out of your organization, but actually coming from partners. And so that doesn't mean simply okay about passing data back and forth and you may lose access to the data. It may mean if for instance we talk about embedded finance, so the underlying idea that part of your retail distribution, for instance, is done with partners and through partners and you only provide the underlying service, that of course you need to make sure that they still comply with regulation, that they don't shine a bad light on you As a banking.

A (5:57)

Institution, what can banks do differently to deal with that risk or mitigate the risk?

C (6:02)

Three things spring to mind. So one is actually really technology. So for instance, there is this trend, what we call instant payments. So the idea that any payment can happen within a couple of seconds. You need technology if you want to look out for fraud risk and if you want to look out for KYC risk in that one. The second thing is of course to have a proper awareness and making sure that risk is not thought in silos, but actually across the different environments. And actually making sure that we think about more than compliance, but actually how it fits together, what are the underlying drivers. And that can make a huge, huge difference. And I think last but not least is actually making sure that you have the proper risk culture and risk compliance culture in the background. We have consistently seen that risk culture is one of the strongest determinants and a positive sense of making sure that institutions and whether it's a traditional bank, a payment company or a stock exchange, steer through all the difficulties. Banks ultimately are. The banking institution are ultimately in the business of taking risk and that will never change, hopefully. But to manage them correctly, it's a combination of technology, but also culture and everything in between.

A (7:08)

So, Reinhard, what do you mean by risk culture?

C (7:11)

I mean risk culture is really a combination of the underlying mindset and the risk practices. So we often think about it as something which cuts across a number of dimensions. So how well do you understand risk? What's your transparency on risk? How much do you acknowledge those risks? There's a third element which is really the responsiveness. So what level of care and what speed do I apply, particularly in some of the faster moving kinds of risk?

A (7:36)

So this was a global study. Alex, what differences did you see across geographies?

B (7:42)

If you look between 2015 and 2022, the changes in total assets that went off banking balance sheet in North America was 79%, was 77% in Europe, but for China it was only 34%. In the rest of Asia Pacific, except for China, it was 51%. In Latin America it was 40%. This is a global phenomena, for sure. In every geography except for Latin America and China, the share that's going off banking balance sheet is more than 50%. One of the really important things is what we see in the Indo Crescent region. It is now home to half of the best performing banks.

C (8:32)

So this region, what we call the Indo Crescent, which starts in East Africa, the Middle East, India, ASEAN and Australia had had the majority of the best performing banks. On the planet, if we cut it up by market cap, it's already 28% of is in this region.

A (8:47)

And to remind our listeners, ASEAN stands for the association of Southeast Asian nations. And it sounds like lots of opportunities are emerging there and elsewhere in the world. But you know, technology provides another big opportunity and it's actually a key area of focus in the report. Alex, what should banks be doing with their technology?

B (9:08)

From a technology and AI standpoint, it is so critical to continue to boost productivity. We've seen the improvements that financial institutions have made, particularly banks over the last decade in improving their cost income ratios, improving their cost per asset to serve. How can they continue to exploit technology, advanced analytics, AI to leverage their talent better to improve the quality and delivery of their products and services, to better meet clients where they want to be met and how they want to be serviced. And we believe that that is both an opportunity to improve client service and customer experience and is also a way for them to continue to innovate the products and services that lenders and other bank and bank financial services customers can get from them.

A (10:02)

What do bank banks have to do to compete on technology? What's changed there?

C (10:07)

So a couple of things have changed. So number one is banks, we should not forget, were one of the earliest adopters of technology back in the 80s. That said, a lot of them still are stuck in the 80s. So they do need to change. And the report, for instance, highlights that in Europe, the best performing banks, so the top 10 invest on average two and a half times more into technology than the bottom 10. So there's a big, big difference in terms of investment. What do they need to change? So number one is they need to leverage the opportunity. At the moment profits are up, meaning investment possibilities up. Number two is, and here we really have a step change is technology is not about simply your core banking system, but in particular generative AI. It is different in the respect that it allows better and simpler customer interactions. It allows using all that soft information which banks have, be it in operations, be it because of customer interviews, be it in terms of monitoring software, that they can leverage that data better and actually give it into usable output, which at the moment requires lots and lots of manual intervention. And the third element is really about the fact is that the barriers to entry have gone down, especially with Genai. So what I mean with that one, it's not just about updating your core system, but for a lot of the stuff, for instance, digitally interacting with your customers and having not just a chatbot which may drive you Insane when you interact with him, it or her. But it's really more about providing the right tonality, providing services, helping your call center agents about that one. And we have often seen the banks who implement them have quick turnaround times of 6, 812 weeks, which is a massive change to what we have seen in the past.

A (11:48)

For the banks that are further along on this technology journey that are investing, what are these banks doing differently in terms of again decision making or investment strategies?

C (12:02)

Multiple tude of answers springs to mind but I would probably highlight the three. So number one, having very clear strategy about where technology is a distinctive advantage for them and where it's maybe more of a hygiene factor and they need to tag along and having a clear idea where to invest. I think the second thing is really about making sure to take the organization along. So one simple example which we have seen when we implemented Genai at one particular client of ours, we've seen the productivity of their coders increase. For the top 25% the increase was massive. For the bottom 25% we actually even saw a decrease initially because they didn't take the people along. I think the third one is however also to really align it with the local regulatory regime, with what their customers actually need and making sure that it's a fitting end to end package and not something where it's rather short term outlook about fixing stuff just to get along and taking a little bit longer view on technology and implementing all the necessary things. Be it agile, be it cloud, be it Genai, be it analytics behind it.

A (13:07)

In the report we talk about the potential need for banks to scale or exit existing businesses as part of this transition. I'm curious, does this present new challenges for banks? Because it feels like banks typically do acquire and divest assets fairly normally. So what's really different here?

C (13:29)

Great question. Thank you. So we highlight this particularly for transactions because that tends to be the most cross border and international part of it. When we talk scaling or exiting, it really means three things. So number one it means think about clearly where are you and do you need to either be big enough to provide it locally, are you actually too small to provide it at scale and find a partner in sense and then exiting might be the answer. Or, or is it actually a mixture of in between that means partnering and so the answer, to give an illustration could be if you're a medium sized institution in the US and you still do everything about security services and capital markets yourself, this is a scale driven business. So we would have to ask the question, is this something Someone else could do better for you. If you ask that same question to a bank in Slovenia, well, the answer might be, well, you're the only one who's really offering it locally and you may not get a good someone else to do it. So you may have to do a locally. And then scaling in the concept of Slovenia may mean, okay, we need to get big up and bigger about that one. I think the third element. And however, and here it's, it's interesting, banks do acquire and divest assets. Historically they have done so. But of course, in the last 15 years of everything after the financial crisis, we've seen much, much less of that. And what we suspect in many respects is that we're going to see somewhat of a pickup activity. The record profits also, so to say, need to go somewhere. You can invest them into your franchise, you can give it back to shareholders or other stakeholders, so to say. Or you can actually also say you think more about M and A. And sometimes the answer is, particularly in the richer ecosystem of fintechs, we're seeing out there, that you may acquire smaller stakes in quite a few of the fintechs and build a partnership network around you without necessarily owning all of them.

A (15:13)

So this talk about acquisitions is making me think again about the balance sheet. Alex, how should traditional players in banking and finance think about these recent changes to the balance sheet?

B (15:26)

From a balance sheet standpoint, we do think that there is the ability to flex and sometimes even unbundle their balance sheet and whether that means figuring out which are the assets that need to remain on their bank balance sheet or are actually better syndicated to others or originated to distribute to other institutions that are better able to hold who have better cost of funding or better duration or better liabilities to match those assets. That would be one, one thing that they could go do.

A (15:58)

Reinhard, anything to add here.

C (16:01)

So the background to this is that we see 70% of the net increase of financial stock happens off balance sheet. What does it mean overall? We see the global source of financial funds in 2022 was 326 trillion. So a huge number out of that, about 37% or 120 trillion were funded off the bank's balance sheet, meaning ultimately there were deposits in the background of bank's liability. Everything else ultimately got funded either by retail investors, for instance, through the stock market, through institutional investors, pension funds, private equity, private debt or sovereign wealth funds. If you look at the relative change from 2015 and 20, the numbers are even starker. So 73% get funded off balance sheet. As we would call it for banks, this is really three opportunities. Number one, it actually means you can do business, which you ordinarily couldn't do. My normal example, if you were to build offshore wind farm and finance it, be it in North Sea, on the Eastern Seaboard or somewhere, somewhere of Japan, for instance, it's very, very difficult to finance via bank's balance sheet. You could find a third party provider, let's say a pension fund, and the bank could help syndicate and actually set this up. Many institutions at the moment don't do it as much as they probably would want to do, and they can do even more of that. The second thing is of course that in terms of managing your own balance sheet, it also allows you to back out some stuff and say, well, we can actually do additional business and actually get some risk diversification into the whole thing. That means for a bank, which for instance may be heavily focused on mortgages, let's say they find a partner, institution or fund or whatever to say they take on some of the risk and that allows the institution to take on additional risk, maybe even of the same kind. There is of course the third element is that even for traditional banks, but of course for everyone else as well, that they could go to other institutions actually onboard someone else's credit exposure in particular, and generate returns out of that. I think a final word here is of course to say what do we mean with a traditional bank? Traditional bank for us is a bank which holds deposits and actually gives out credit facilities. But in theory it's always worth remembering that many, many people can directly hold assets themselves. And any of us who invest into stocks or ETF ultimately are doing exactly that.

A (18:22)

For any bank, whether it's a traditional bank or are not so traditional to think differently about the balance sheet, how hard or how easy is it to to change course and what kinds of conversations do you need to have inside the organization to make things happen?

C (18:39)

A lot of conversations. It's a very complex issue for some of institutions. So number one, it often starts with the way you think about risk. Just because you may be able to use other partners of handling risk doesn't mean you lose all the responsibility on that. So the traditional example, if you look at the financial crisis, and part of the reason for the financial crisis was that we just offloaded risk to someone else and then it was kind of forgotten and we ran into trouble later on. So this really runs into a situation where your own internal risk has to think about it, what does it do? But also to be cognizant of that one, just because your balance sheet may not be able to hold onto something, doesn't mean that someone else doesn't. And number two means that the way you interact with partners, particularly financing partners, or if you're a financing partner with the banks, needs to be much, much more up to scale. We have always seen in the industry syndications. So for very large loans, bank would syndicate something to bigger institutional investors. A relatively manual process got more digital over the last couple of years, but effectively doing this all the time, the more we are going to move more broad bases, the more automated, the more digital that needs to become. And I think the third thing is of course to really make sure both from a culture but also from a commercial go to market strategy that you recognize that one, it's a very, very different thing if you go out with a mindset. I'm doing mortgages, I'm doing corporate loans from my own balance sheet versus I'm doing something where I can actually also pass it on to partners. The final point is of course also for the investors to make sure that their risk capabilities are up to scratch. They are often differently regulated and they also have a fiduciary duty, be it a private equity fund, be it a pension fund, to make sure that this aligns with what they are looking after.

A (20:23)

So as we wrap up, what's the first thing financial executives should prioritize?

C (20:30)

So first and foremost, everyone should recognize that we're entering a new era. The next five or maybe 15 years are going to look very different than the last 15 years of very low interest rates. And that means that your strategy, that means your operation, your culture and everything around that needs to acknowledge that and needs to also think differently about how to deal with this future.

A (20:52)

Okay, first step, acknowledge a new era. How about you, Alex?

B (20:57)

Institutions are not doomed by their own business model. They're not doomed from birth. How you react to the changes in balance sheet, for some this is about being defensive. For some, it's about going on the offense. For some, it's about changing the business model a little bit. If you can't take these assets onto your balance sheet, who is the natural owner of them and can you originate to distribute? So those are the types of changes that we see by different subsector in this vast and growing global ecosystem. Despite all the uncertainty that exists, macroeconomic, geopolitical, technological, and despite all of the turmoil that happened last year and this year, banking saw its highest profits in more than a decade. They earned in 20, 22, 12% return on equity and 13% in 2023 so far, and that compares with a 9% average since 2010. So despite all of the turmoil, despite all that that's happened, they've actually done very well.

A (22:10)

Alex Reinhart, thank you so much for taking the time today and talking through the findings.

B (22:16)

It was great to be here. Great to see you.

C (22:18)

Pleasure to be here. Thank you.

A (22:21)

Thanks so much for listening to the McKinsey Podcast. I'm Lucia Rahilly. And I'm Roberta Fassaro. Find us on McKinsey.com, we'll have a transcript of this episode up shortly. And download the McKinsey Insights app where you can find this podcast and other helpful content updated daily. If you enjoyed the show, we'd love for you to leave a rating and a review. We'll see you in two weeks.