THE FUTURE OF BANKING IN EMERGING MARKETS · markets – this compares very favorably to the ca....

Financial Services

THE FUTURE OF BANKING IN EMERGING MARKETS

TABLE OF CONTENTS

1. INTRODUCTION 1

2. THE ULTIMATE GROWTH STORY 4

3. RETAIL: THE GROWTH ENGINE 8

4. WHAT ABOUT PROFITS? 12

5. THE MAJOR UNCERTAINTIES 18

6. REGIONAL VARIATIONS IN THE NEAR-TERM 24

7. IMPERATIVES FOR BANKS IN EMERGING MARKETS 28

7.1 MANAGING MULTI-COUNTRY PORTFOLIOS 28

7.2. OPTIMISING LOCAL OPERATIONS 31

CONCLUSION 35

1. INTRODUCTION

Several emerging economies have grown at extraordinary rates over recent years, China,

India and Brazil most obvious among them. Their banking sectors have grown even

faster, as tens of millions of their previously impoverished citizens have moved above the

“bankable” income threshold while technological innovations, such as mobile banking, have

simultaneously lowered that threshold.

ExhIBIT 1: BANKING REVENUE GROWTh IN SELECTED MARKETS BETWEEN 2001 AND 2009

4x

2x

6x

US EU* Canada China Lower middleincome†

Upper middleincome‡

5% 4% 4% 23% 22% 22%

0x

8x

BANKING REVENUE IN 2009/2001

CAGR’01-’09

1.4x 1.3x 1.2x

5.4x5.0x

6.0x

KEY EMERGING MARKETS(BRIC Average = 7.4x)

* Germany, Spain, France, Italy, Austria, Belgium, Denmark, Norway, Sweden, Switzerland

India, Egypt, Indonesia, Nigeria

‡ Brazil, Russia, GCC, Malaysia, Mexico, RSA

Source: OECD, Bankscope, Oliver Wyman analysis

Yet this development is still in its early stages. In most emerging markets, the banking

market remains immature. Compared to the West, only a small portion of their populations

have bank accounts, consumer credit is limited to small typically unsecured lines with

mortgage markets still mostly undeveloped.

Copyright © 2011 Oliver Wyman 1

ExhIBIT 2: PENETRATION OF BANKING SERVICES IN DEVELOPED AND EMERGING MARKETS – A COMPARISON

China 119%** 37%

34%

55%

90%

57%

162%

Lower MiddleIncome*

Upper MiddleIncome†

DevelopedAverage‡

50% 100% 150% 200% 50%25% 75% 100%

BANKING CREDIT PENETRATION(Total credit/GDP – 2010E)

BANKED POPULATION(% adults using financial services, 2008)

KEY

EM

ERG

ING

MA

RK

ETS

0%

37%

0%

Notes: Scope for all metrics includes both retail and wholesale

* India, Egypt, Indonesia, Nigeria

Brazil, Russia, GCC, Malaysia, Mexico, RSA, Turkey

‡ France, Germany, Italy, Spain, US, Canada (excl. UK)

** high credit penetration due to state encouraged corporate/public sector lending, particular, for infrastructure and increased lending post crisis

Sources: IMF, OECD, Central Banks, SNL, Oliver Wyman analysis, Financial Access Initiative & CGAP

As a result of the above, banking revenues, as a percentage of GDP, are still small in emerging

markets – especially when one compares them to developed economics. Banking revenues

per citizen remain relatively low. In other words, despite recent growth, emerging markets

banking still offers great growth potential for incumbents and new entrants alike – especially

when compared to stagnant and saturated Western markets.

ExhIBIT 3: BANKING REVENUE ShARE OF GDP – CROSS-COUNTRY COMPARISON

12%

10%

8%

6%

4%

2%

Lower middleincome countries*

Upper middleincome countries*

High incomecountries*

0%

22%

BANKING REVENUE†

SHARE OF GDP

80-20 percentile range

VietnamNigeria

ThailandIndiaChinaEgypt

Russia Spain

Canada

France

Japan

UKSwitzerland

GCC

Mexico

South Africa

MalaysiaBrazilTurkeyChile

Indonesia

ItalyAustraliaGermanyUS

…

* Income categories defined using GDP per capita (PPP) as per World Bank Atlas classification methodology

2009 revenue based on all banking revenue – retail and commercial


Of course, some of the appearance of economic growth in emerging markets may be due

to asset price bubbles. Nor is this the only risk to the smooth progress of these economies.

Trade protectionism, political instability (perhaps caused by rising income inequality), poor

infrastructure and underdeveloped liberal institutions, most importantly the rule of law,

could all lead to trouble in the future.

But we are broadly optimistic. The growing wealth of these populations and their increasing

levels of education should help to promote the required institutional and infrastructural

frameworks. In addition, the relentless advance of technology combined with the sheer

weight of demographics mean that, even if progress is stuttering and uneven, the banking

markets of emerging economies will be significantly larger in 10 years than they are today.

In this paper we present our projections for the growth of banking in the twelve emerging

economies that we believe provide the most attractive opportunities: Brazil, China, Egypt,

the GCC countries, India, Indonesia, Malaysia, Mexico, Nigeria, Russia, South Africa and

Turkey. We consider the risks to this growth, estimate how it will translate into bank revenues

and profits, consider the growth potential of retail, define priorities for the near-term and,

finally, give some advice for banks looking to compete in emerging markets.


2. ThE ULTIMATE GROWTh STORY

A robust growth outlook in emerging markets banking is evident, but what is the “size of the

prize”? Will emerging markets banking sectors rival developed markets? If so, by when? To answer

these questions, we have looked at trends in banking growth over several decades in countries at

various stages of development. We find that banking broadly grows with the economy but at a

much faster rate during certain “golden growth” stages. The pace of growth is further influenced,

positively or negatively, by structural factors, primarily legal and regulatory.

It is well-known that banking growth is strongly linked to economic growth1. This

relationship is especially strong over longer time horizons in both developed and emerging

markets forming a virtuous cycle as banking in turn promotes economic growth. At various

points in development, banking grows at a premium to GDP growth. The premium is found

to be highest as countries move through the “middle income2” growth phase. This is the

phase when the rise in per capita income result in step-change increases in the bankable

population of a country. The effect continues as the rising wealth leads to customers

accessing a broader range of services, on the one hand, and increasing sophistication

in product offerings, on the other, particularly to serve more long-term investment and

financing needs.

ExhIBIT 4: RELATIONShIP BETWEEN BANKING REVENUE GROWTh AND ECONOMIC GROWTh OVER LONG TIME PERIODS

Developed markettrend

Developed markets(’80-’07)

GR

OW

TH IN

BA

NK

ING

BA

NK

ING

GR

OW

TH P

REM

IUM

O

VER

GD

P G

RO

WTH

GROWTH IN NOMINAL GDP

RATIO OF BANKING GROWTH CAGR AND GDP GROWTH CAGR (OVER 10 YEAR PERIODS)

LONG TERM CAGR OFBANKING REVENUE VS. GDP

Brazil

UAETurkey

Qatar

Nigeria

IndonesiaChina

EgyptKuwait

OmanMalaysia

IndiaBrazil

South Africa

MexicoSaudi Arabia

Korea

Spain

FranceBelgium

GermanyItaly

SwedenSwitzerlandAustria

NorwayUS

GCC

Low or middleincome

Upper middleincome

Highincome

80-20 percentilerange

Emerging markettrend

Emerging markets(’01-’09)

0.4x

2.0x

0.6x

0.8x

1.0x

1.2x

1.4x

1.6x

1.8x

Notes: CAGR = Compound Annual Growth Rate; Income categories based on the World Bank Atlas methodology for country classification

Source: OECD, Bankscope, Oliver Wyman analysis

1 Measured by GDP growth; Goldsmith (1969), Jaffe and Levonian (2001).2 Country classification based on income levels (or per capita GDP levels) using thresholds defined by the World Bank Atlas

methodology, equivalent PPP GDP bands as follows – lower middle income: $2 K-6 K, upper middle income: $6 K-15 K, high income: $15 K+ (but all selected markets are at $30 K+ levels).


Our target markets are uniquely positioned to produce this high growth as they are all

moving through the middle income phase. Increasing wealth is boosting consumption,

fuelling growth in both lending and wealth. Unprecedented growth trajectories can be

observed in markets such as Turkey and South Africa that entered this phase in the last

decade. This acceleration in growth is accompanied by an increasing contribution of

banking revenues to GDP and only slows down as countries move into higher income

brackets, ultimately reaching parity with GDP growth as banking contribution to the

economy plateaus at average levels of 8 to 10%3 of GDP.

A range of macro-economic, demographic and other factors (such as regulation, legal

framework, etc.) explain the variation in the premium of banking growth over GDP growth.

We have investigated these factors in detail – the methodology is discussed in further

detail in the box below – and incorporated our learnings into 20-year forecasts for key

emerging markets.

Overall, we expect low income countries with high potential and medium enablement

including India, Indonesia, China and Egypt to experience significant growth. Even

though the financial infrastructure in these markets has some way to go, the high growth

momentum is likely to stimulate a positive evolution. We also expect high but less aggressive

growth in markets such Turkey, Malaysia and South Africa due to their already sizable

banking sectors and as they mature into high income markets in the next 10 to 20 years.

Growth forecasts were also evaluated in light of the capitalisation of the banking sector and

the long term availability of adequate (term) funding. Markets with higher core capitalisation

levels such as Brazil with ~10-15% are better positioned for funding growth. Markets with

recent lower capital levels such as China have already increased capital-raising efforts

moving from the ~5-6% core capital observed in 2009-10 to ~10% in early 2011 driven only

partially by the regulator. Rising wealth and shifting demographics also lead to increasing

levels of retail deposit funding to fuel this growth. however, the rise of retail consumption is

acting as a dampener by causing savings rates to decline in markets such as Indonesia, Brazil

and Turkey. These countries will need to urgently develop longer term funding markets to

remain on course for continued growth.

Overall, we expect banking revenues in our target markets to increase to ca. ~3 to 4 times

their current levels over the next decade4 and to ~7 to 8 times current levels by 2030

compared to GDP growth of ~2 and ~6 times over the same time periods. In absolute

numbers, by 2030 we expect ca. ~$5 TN of banking revenue growth in these target emerging

markets – this compares very favorably to the ca. ~$4 TN in banking revenue growth

expected from developed markets in the same period.

3 Markets with a higher focus on financial services, such as the UK, surpass this level.4 For comparison, the last decade saw banking sectors in some of these markets growing by 5 to 7 times.


INVESTIGATING ThE BANKING GROWTh MULTIPLIER

Apart from the effect of rising income levels explained earlier, variations in the banking multiplier are affected by the financial infrastructure supporting the banking sector. This has three parts – legal, regulatory and market-based mechanisms. A robust legal framework that guarantees property rights, consumer protection and long-term asset value preservation is a pre-requisite for growth. Rule of law alone is insufficient; fast and effective enforcement are the real drivers. For the banking sector in particular, lack of clear property rights and enforceability of contractual obligations can prohibit development of whole groups of products such as long term credit products. Support from a broad regulatory framework that balances systemic stability, prudential regulation and consumer protection without being overly restrictive positively influences growth. Market support mechanisms, such as credit bureaus, and the availability of accurate data, such as the recent developments in collecting positive credit information in Brazil, also boost growth and development of competitive banking product ranges.

In order to model the evolution of banking revenues, we have used a broad assessment framework to consider factors across a range of dimensions. Analysis of over forty factors reveals that most of the banking growth “multiplier” (over economic growth) is explained by five factors: income levels, contribution of banking to the economy5, penetration of the bankable population, legal protectiveness and regulatory environment. The expected evolution of these primary factors drives our base-case revenue forecasts.

Taking economic growth (measured as GDP growth) as the basis, we apply a “growth multiplier” derived from the

5 Measured by banking share of GDP.

above factors to estimate banking revenue growth for each individual market. The base case revenue projections are built on GDP growth forecasts from widely available market sources6. We have further fine-tuned our outlook based on market-specific idiosyncrasies and unique bank behaviour observed in different markets7. For example, in Mexico, a combination of the high income skews8 and aggressive targeting of low income segments by banks is expected to accelerate growth when compared to peers.

6 IMF – projections available to 2015; Economist Intelligence Unit (EIU) – projections available to 2030; consistent haircut of 10% applied across markets for conservatism.

7 Informed by our work with leading players across the globe8 Mexico consistently ranks high in inequality indices (Gini coefficient of 51.6 in

2008 – World Bank).

ExhIBIT 5: WhAT DRIVES ThE “BANKING GROWTh MULTIPLIER”?

DETERMINANTS OF BANKING GROWTH MULTIPLIER

GROWTHPOTENTIAL

KEY ENABLERS

KEYENABLERS

OUTLOOK ON BANKING GROWTH MULTIPLIER FOREMERGING MARKETS (2010-2030)

Income levels

GR

OW

TH P

OTE

NTI

AL

High

LowAbsent/ Nascent/ Restrictive

Well-formulated/Less restrictive

Bankingcontribution to GDP

Low access to banking

Adequate legal protections

Low Regulatory Restrictiveness

India

China

IndonesiaEgypt

MexicoNigeriaGCC

BrazilMalaysia Turkey

Russia

South Afraica

1

2

3

4

5

Notes: Growth Potential is a combined measure of income level, banking revenue share of GDP, banking access levels today; Key Enablers measures the evolution of legal protectiveness, non-restrictive regulations

As shown in Exhibit 5 above, relative growth will vary greatly as some of the markets we analyse will mature into high-income

brackets in the next decade.


ExhIBIT 6: ESTIMATED SIZE OF BANKING SECTORS IN 2020 AND 2030

CAGR(’10-’30)

CAGR(’10-’30)

9.0%4.9%

11.0%5.0%

CAGR(’10-’30)

60

40

20

80

2010E 2020F 2030F

0

100

GDP(NOMINAL US$ TN)

Ind

ones

ia

Egyp

t

Ch

ina

Turk

ey

Nig

eria

Mal

aysi

a

Sou

thA

fric

a

GC

C

Mex

ico

Bra

zil

Ru

ssia

Dev

elop

ed

6

4

2

8

2010E 2020F 2030F

0

10

BANKING REVENUES(US$ TN)

US

Other Key Developed**

Upper Middle Income‡

Lower Middle Income†

China

FORECASTED SIZE OF BANKING SECTORS* (2010E REVENUES)

PROJECTED BANKING SECTOR GROWTH (2010E = 1x)

DM: 2010E-2020F

DM: 2020F-2030F

EM: 2010E-2020F

EM: 2020F-2030F

Ind

ia

4.2x

2.8x

4.2x

2.7x

3.9x

2.8x

4.1x

2.6x

3.0x

2.5x

2.6x

2.0x

2.7x

1.9x

2.0x

2.4x

2.3x

1.9x

1.5x

1.7x

5%

2.2x

1.7x

2.2x

1.9x

13% 13% 13% 13% 11% 9% 8% 8% 8% 7%7%8%

1.8x

2.4x

* Defined as total revenues of all banks in the country

India, Egypt, Indonesia, Nigeria

‡ Brazil, Russia, GCC, Malaysia, Mexico, South Africa & Turkey

** France, Germany, Italy, Spain, UK, Japan, Canada

Source: GDP – IMF, EIU with slight dampening for conservatism


3. RETAIL: ThE GROWTh ENGINE

We expect retail banking to be a major driver of the growth in emerging markets. This is a natural

evolution, driven by well-known trends such as increasing bankable populations, rising income

and financial awareness and currently low retail penetrations. Advances in technology and the

rise of low-cost options such as mobile banking will also accelerate growth in these markets and

open up previously unprofitable segments.

As evident from the exhibits below, emerging markets lag far behind developed markets

across a variety of retail banking demand and supply metrics.

ExhIBIT 7: RETAIL BANKING PENETRATION IN DEVELOPED AND EMERGING MARKETS – A COMPARISON

60%

40%

20%

Lower middleincome*

11%

23%

65%

Upper middleincome†

Developedaverage‡

0%

80%

RETAIL CREDIT PENETRATIONRetail credit** as % of GDP (2010E)

3,000

2,000

1,000

Lower middleincome*

606

1,563

3,016


Developedaverage‡

0

4,000

DEPOSIT ACCOUNT PENETRATION# of deposit accounts/1000 adults (2009E)

60%

40%

20%

Lower middleincome*

6%11%

47%


Developedaverage‡

0%

80%

MORTGAGE PENETRATIONRetail mortgages as % of GDP (2010E)

60

40

20

Lower middleincome*

9.4 14.0

63.1


Developedaverage‡

0

80

BRANCH PENETRATIONBank Branches/1000 adults (2009E)

BRIC

BRICBRIC

BRIC


Brazil, Russia, GCC, Malaysia, Mexico, South Africa & Turkey

‡ France, Germany, Italy, Spain, US, Japan (penetration), excl UK/Canada

** Retail Credit Includes mortgages, credit cards and other consumer finance, excludes SME

Source: Central Banks, CGAP, IMF OECD


Likewise, our target markets are still underpenetrated in retail with large swathes of their

bankable population unbanked or under-banked. We estimate that retail banking in

emerging markets today accounts for less than ~35% of total banking revenues and ~30% of

total credit. Additionally, if credit is looked at relative to GDP this falls even further to levels of

10-20% when compared to developed markets levels of 60%+.

ExhIBIT 8: RETAIL REVENUE AS A % OF TOTAL BANKING REVENUE – 2010E

75%

50%

25%

China

34%

Lower middleIncome*


Developed‡

average

KEY EMERGING MARKETS

0%

100%

Retail

Wholesale/Other30% 35%

50%

Expected retail revenueshare of total

in 2020F = ~45%



‡ France, Germany, Spain, Italy, US

Source: Oliver Wyman propriety data, Central Bank

This situation is the norm – rather than exception: as a country develops, its banking

sector evolves – typically starting with “safe and simple” products, such as lending to the

government, public sector and blue-chip corporates, followed by “easy short-term” retail

products, such as credit cards. This is followed by the emergence of more complex longer-

term retail products, such as mortgages, and customer segments that require more complex

operating models, such as SME/middle market. A robust legal framework underpins growth

at almost all stages but is especially important for sustained growth in complex products.

The growth of mortgages, for example, depends heavily on the emergence of a long-dated

yield curve.


ExhIBIT 9: BANKING SECTOR EVOLUTION

• Mainly commercial lending – primarily asset-based/ small mortgage market

• Traditional brick-and-mortar institutions providing current and savings accounts

• Limited SME focus

• Easy lending to low-risk consumer segments, simple credit e.g. credit cards, payday loans

• Term deposits with di�erentiated rates/ packages

• Dedicated SME proposition

• Working capital loans, consumer finance, growth in mortgages

• Advent of simple investment products, and proliferation of innovative channels e.g. online banking

• Di�erentiated SME o�erings

• Complex o�erings, well developed mortgage market

• Lower risk alternatives for the mass market (e.g. retail structured products)

• Well segmented SME o�erings

WHOLESALEBEGINNINGS

RETAIL GROWTH MATURATION COMPLEXITY1 2 3 4

Nigeria Egypt India China Brazil Turkey

Indonesia Mexico Russia Malaysia Japan

Spain France US UK

GCC

Simplified Banking Evolutionary Path

While they are all at very different stages of this evolution – as evident in Exhibit 9 above – we

currently see all of our target markets without exception moving from left to the right – albeit

at different paces. Even “frontier” markets like Nigeria have, in the last five years, taken

big strides through improving banking regulations, governance standards and consumer

protection, establishing credit bureaus, etc.

The growth in retail is further supported by high population levels, forecasted population

growth particularly in young and working age brackets, and increasing urbanisation levels.

All target emerging markets are uniquely advantaged in this respect due to these positive

demographic trends driving significant increases in bankable population albeit subject to

population control policies. We estimate an addition of nearly one billion “bankable” people

across our target markets in the next decade, with China and India accounting for ~70%

of this increase. This exceeds by ~25 times, the ~40-50 MM increase expected in the top

developed markets. Some near-term high-growth markets, such as Brazil, will see the bulk of

their growth in the coming decade whereas others such as India and Indonesia will continue

to see significant bankable population growth in the decade thereafter.


ExhIBIT 10: BANKABLE POPULATION LEVELS ACROSS MARKETS AT 2010 AND 2020 (IN MM)

Ch

ina

Ind

ia

Ind

ones

ia

Bra

zil

Ru

ssia

Nig

eria

Mex

ico

Turk

ey

Egyp

t

RSA

GC

C

Mal

aysi

a

US

483

614414

375

Ger

man

y

UK

Ital

y

Fran

ce

Spai

n

Bankable population in 2010

Bankable population added between 2010and 2020

Bankable population added between 2010 and 2020 ~1,000 MM ~40 MM

76

62

108

26

92

8

36

3862 45

5 102528 27

5

236

15

242

28

69 50 49 49 37

23 1 26

Source: EIU, Oxford Economics, IMF

Finally, innovation across the value chain is a key component driving the growth in

emerging markets. The rise of mobile banking and low-cost IT platforms to move “down the

pyramid” and serve lower income segments are cases in point. Scalable mobile payment

products such as M-Pesa and SMART Money9 have set a precedent as viable delivery

channels to low income consumers. Banks typically start with simple payment products

and aim to move up the value chain to savings and credit products as consumers become

more familiar with branchless banking channels. Brazil, for instance, has seen several

branchless payment solutions flood the market including M-Cash, EverMobile, Oi Paggo.

Leveraging emerging technology initiatives, such as the government-led UID card in India,

can help drive increasing financial inclusion using innovative platforms and distribution

approaches. Additionally capture of niche but growing segments such as remittances

in retail, international banking products for SME, will start becoming more attractive in

these markets.

Overall, all our target markets are poised for strong growth in retail. Consequently, we expect

retail banking to be the main engine of bank revenue growth – accounting for more than half

(~55-60%) over the next decade providing a trillion dollar revenue opportunity for banks.

9 In Kenya and Philippines respectively.


4. WhAT ABOUT PROFITS?

Emerging markets present an untapped revenue opportunity but for a bank CEO the focus is,

ultimately, on the bottom line. In this chapter, we look at the key drivers of profitability including

margins, operating costs, risk costs and regulation. The picture here is more nuanced. Asset

margins have remained high and largely sticky through the last decade albeit with variations.

In the long-term, we expect them to come down as these markets mature. At the same time, we

expect to see improvement in operating costs, risk costs (albeit at a slower pace) and regulatory

environment – for different reasons. Overall, profits present an attractive but potentially

risky opportunity.

Margins – the high interest rate environment of the past has been conducive to healthy

margins. Due to the immaturity of these markets, emerging markets banks have thus far

been free to “cherry-pick” customers and focus on high margin business. This has allowed

banks to grow their asset base rapidly and without any dilution in margins – a key reason

for the unprecedented revenue growth (20-30% CAGR) observed in markets such as Russia, Turkey and Brazil in the last decade. Margins have largely been maintained or even seen some growth in these markets.

Operating costs have at the same time declined only slightly and in some markets they

have even increased. Markets in an early stage of banking sector evolution, such as Nigeria

and Egypt, are making significant investments in technology and infrastructure on the

back of growth, leading to increased costs. Many of these markets have access to cheap

talent that could ultimately give them a cost advantage but this is yet to be realised in many

markets. In other markets such as the GCC, costs have been kept down by low labour costs,

liberal labour laws and the focus on corporate banking.

ExhIBIT 11: MARGIN EVOLUTION IN EMERGING MARKETS

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

EMERGING MARKETS REVENUE* OVER ASSETS (ROA)1999-2009

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

EMERGING MARKETS COST† OVER ASSETS (COA) 1999-2009

8%

9%

7%

6%

5%

4%

3%

2%

10%

1%

11%

8%

9%

7%

6%

5%

4%

3%

2%

10%

1%

11%

Spread of ROAs (80-20 percentile)

Trendline on average ROA

Average of all target emerging in markets

* Net interest income and non-interest operating income

Operating costs (excl. interest expense)

Source: Bankscope, OECD


Risk costs in emerging markets, on the other hand, remain high although differences

in reporting standards and inaccuracies in reporting can obscure the data. Risks costs of

three to five times the level observed in developed markets are common. As most of these

markets experience a boom in retail banking over the next decade, these costs may normally

be expected to rise. however, we expect this to be offset, to some extent, by advances in

risk management and growth in securitised products. Some markets, such as China and

the GCC, that today enjoy loss rates at the level of developed markets should expect to see

increases. In China, the state-encouraged credit boom of recent years will inevitably increase

risk costs, particularly in the medium-term. In the GCC, the continued move towards SME

and mid-market is expected to contribute towards this increase.

Regulations affect profitability substantially in emerging markets and have served to

artificially raise or lower profits for extended periods of time. Large state-owned banking

sectors in markets such as China and India have given politicians and regulators powerful

influence, though in opposing ways. In China, the largely state-owned banking sector

has profited from mandated caps and floors on credit and deposit rates. Current policy

favours the state-owned domestic behemoths with large branch networks. The externally

determined profitability has kept the banking sector somewhat stable although concerns

on non-performing loan (NPL) visibility remain. Because the artificial caps and floors on

pricing lead to profitability greater than would be achieved by a fully market-based system,

the impending gradual trend towards liberalisation is fraught with risks. In India, on the

other hand, the “activist” approach of the central bank has largely been focused on financial

inclusion (such as the levying of priority sector lending targets) and rules-based consumer

protection regulations. This approach has generally affected the profitability of banks in a

negative manner. On the flip side, it has also led to greater transparency and has allowed the

regulators to rein in rampant credit growth.

The focus on growth thus far has led to a relatively benign competitive landscape in some

of our markets. But this will not last as high returns, latent opportunity and gradual opening

of markets lead to increasing competition. Interestingly, our analysis shows that it is not the

number of banks but the behaviour of banks that drive margin pressures.


MARKET CONCENTRATION AND MARGINS – ExPLORING ThE RELATIONShIP

We looked at the relationship between margins and the herfindahl – hirschman Index (hhI), which is often used as a proxy for market concentration. What we find is that a lower bank concentration does not necessarily translate into lower margins.

ExhIBIT 12: RELATIONShIP OF MARGINS (ROA) WITh LEVEL OF BANK CONCENTRATION (MEASURED AS hhI)

4%

2%

8%

6%

HHI

0%

10%

REVENUE OVER ASSETS(2007-2009 AVERAGE)

0.30.250.20.150.10.050Emerging Markets

Developed Markets

Nicaragua

Brazil

Mexico

Oman

Qatar

Switzerland

Sweden

KSAUAE

Bahrain

KuwaitSpain

Italy

CanadaFranceGeorgia

Korea

China

Egypt

IndiaMalaysia

US

TurkeyIndonesia

Russia

South Africa

Notes: hhIs computed using market shares based on banking assets. Developed markets – France, Germany, Italy, Spain, United States, Canada, Korea, Sweden and Switzerland Emerging markets – Brazil, China, Egypt, India, Indonesia, Malaysia, Mexico, Nigeria, Turkey, Russia, South Africa and GCC


The case of South Africa and Russia in Exhibit 12 above serve to illustrate this point. The South African banking sector is highly concentrated with the largest four banks accounting for 80% of the market (hhI ~0.2). The few large banks compete intensely and with increasing pressure on margins. however, they have also proactively adopted best practices in terms of management, risk management and new technology enabling them to sustain their cost-income levels even at lower margins. The Russian banking sector, on the other hand, has high margins despite the large number of banks. With nearly 1,000 banks (an hhI of ~0.1), it is markedly less competitive than other BRIC markets10 with 200-400 banks. Large, state-owned banks wield higher market power than smaller, privately owned institutions.

10 Report on banking sector competition in Russia, The World Bank Group.


From the perspective of both gross margins and costs, our focus markets are at an early point

in their evolution. We expect profitability to decline as they mature. Margins will inevitably

be hit as competition intensifies. This will be led by new entrants aiming to gain share, non-

standard entrants upping the game and players increasing sophistication across the board.

We are already observing this in the slew of foreign entrants and cross-border bank entry, such

as seen in Russia and Turkey in the last decade, and non-standard entrants, such as Walmart

bank in Mexico and mobile banking players across most emerging markets. Although the

current inflationary environment keeps both costs and gross margins high, these pressures will

dampen in the long term. The high interest rates observed today are expected to decline over

the long-term. As gross margins come under pressure, banks will need to start paying more

attention to costs and increase efficiency. Additionally, broadening product ranges and serving

customers in higher risk segments will further contribute to margin pressures.

A long-term view of developed markets confirms this view. Margins, as expected, have

been plagued by volatility in the short-term, but in the very long-term in the light of several

economic and credit cycles, the trend has been that of a clear steady decline. Banks have

coped with this margin decline by increasing operational efficiency as evidenced by the

parallel decline in costs as seen in Exhibit 13 below.

ExhIBIT 13: EVOLUTION OF BANKING PROFITS IN DEVELOPED MARKETS

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

DEVELOPED MARKETS REVENUE* OVER ASSETS (ROA)1980-2007

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

DEVELOPED MARKETS COST† OVER ASSETS (COA)1980-2009

Spread of ROAs (80-20 percentile)

Trendline on average ROA

Average of developed markets

3.5%

4.0%

3.0%

2.5%

2.0%

1.5%

4.5%

1.0%

5.0%

3.5%

4.0%

3.0%

2.5%

2.0%

1.5%

4.5%

1.0%

5.0%

* Net interest income and non-interest operating income

Operating costs (excl. interest expense)



TRENDS IN PROFITABILITY – KEY FACTOR ANALYSIS

We have used a broad assessment framework across macroeconomic, demographic and banking sector factors to determine key drivers of cost and gross margin ratios. The evolution of these fundamentals drive profits projections.

KEY FACTORS USED FOR PREDICTING PROFITABILITY EVOLUTION – COST SCORECARD COST Scorecard

KEY FACTORS (CORRELATION*) OBSERVED RELATIONSHIP

Income levels • Strong negative relationship empirically observed across long timeframes

• Income levels also broadly serve as a measure of market maturity

Population density • Densely populated countries tend to have lower costs as cost of serving

reduces with density

• Simple population density metrics (over entire countries) are insufficient –

inhabited land population densities used

historical costs • Long-term structural decrease is affected by historical cost ratios level

observed in a country

Skilled labour availability • Staff costs (largest component of operating costs) are highly dependent on the

availability of labour. Rigid labour laws can further increase costs

Infrastructure costs • Costs of “operations” or doing business is particularly important in

infrastructure-poor markets

• E.g. high costs in Nigeria driven by lack of reliable basic infrastructure items

such as electricity

ROA Scorecard

KEY FACTORS (CORRELATION*) OBSERVED RELATIONSHIP

Income levels • Strong negative relationship empirically observed across long timeframes

• Income levels also broadly serve as a measure of market maturity

Population • Impact on margins specially in countries with very high populations owing to

large absolute size of untapped market

Interest Rates • Strong direct positive relationship with margins

historical Margins • Long-term structural trends are affected by the starting level observed in

a country

Cost levels • high cost base forces banks to serve only high margin segment/with high

margin products to maintain profitability e.g. Nigeria

Positive correlation – implies ratio increases with increase in this factor

Negative correlation – implies ratio decreases with increase in this

Note: Although competition is a significant driver, existing objective measures of competition are poor predictors of margins

*


Today, our 12 target markets together have an operating profit pool equal to half the size of

major developed markets11. By 2020, we expect this to grow to be equal. however, higher

margin compression in the following decade is expected to dampen growth from 10-11%

CAGR in the next decade to 8-9% in the following decade.

Emerging markets tend to be riskier than developed markets. Additionally, banks will need

to expand their reach and move down the risk spectrum into mid-market, SME and subprime

segments. hence, we expect risk costs to remain at the current high levels over the next

decade and even increase in some markets. Some improvements are expected in the long

run with increasing sophistication. Risk-adjusted profits in emerging markets will therefore

grow slower and will take another decade to equal the size of developed markets.

A discussion of profits is incomplete without understanding the capital story and the

implications for sustainability of this growth. We must distinguish between markets that

are well-capitalised from those with higher leverage. Low capitalisation can lead to unstable

growth. Amongst our target markets, we see China being at the wrong end of the spectrum

with low capitalisation levels of 5-6% in the banking sector that threaten the sustainability

of growth. At the other end of the spectrum, markets like Brazil and Russia, with higher

capitalisation of 10-15%, are better positioned to generate stable and sustained growth.

11 US, UK, France, Germany, Italy, Spain, Canada, Japan.

ExhIBIT 14: PROFIT POOLS

3

2

1

2010E

0.4

1.01.4

0.30.6

1.6

3.3

2.7

2020F 2030F

0

4

OPERATING PROFIT (US$ TN)Measured as [Revenues] – [OPEX]

3

2

1

2010F 2020F 2030F

0

4

RISK-ADJUSTED OPERATING PROFIT (US$ TN)Measured as [Operating profit] – [Expected loss* ]

China

Other target emerging‡

US

Other Key Developed†0.8

1.1

2.0 1.9

* Based on impairment charges from Bankscope and analyst reports; 10% higher loss assumed in emerging markets over impairment charges for conservatism. Outlook on EL is based on observed historical trends in developed markets

France, Germany, Italy, Spain, UK, Japan, Canada

‡ India, Egypt, Indonesia, Nigeria, Brazil, Russia, GCC, Malaysia, Mexico, South Africa & Turkey


5. ThE MAJOR UNCERTAINTIES

As with all predictions, the positive outlook is subject to some risks. In this section, we

identify the primary uncertainties and lay out the potential future scenarios across emerging

markets that players must prepare for.

The projected banking growth in emerging markets will result in fundamental shifts in the

global banking landscape. By 2030, we expect emerging and developed markets to broadly

command an equal share of global banking revenues as shown in Exhibit 15 below. however,

these projections should be treated with caution because they are subject to a number

of uncertainties.

ExhIBIT 15: ExPECTED EVOLUTION OF BANKING REVENUES

100%80%60%40%20% 90%70%50%30%10%

BANKING REVENUE AS % OF TOTAL(FOR TARGET MARKETS)

Target marketsas % world

Bankingrevenue GDP

~80%

3%

2020F 17% 6% 14% 26% 37%

2010E 8% 12% 28% 49%

2030F 31%24%14%9%23%

~75%

85-90% ~80%

China

Lower Middle Income*

Upper Middle Income†

US

Other Key Developed‡

0%



‡ France, Germany, Italy, Spain, UK, Japan, Canada

Source: IMF, EIU, Oliver Wyman analysis

The expected sustained high GDP growth might not be realised. Some or even all of our

focus markets might not reach their expected potential over the next two decades. Looking

at an example from the past helps to put this into perspective. In the early 1900s, both the

United States and Argentina were buoyant emerging markets full of promise. While the

United States exceeded expectations, Argentina eventually stagnated and went into decline.

This appears to be unlikely for the target markets but the risk remains. The exact set of

reasons for such stagnation varies by market; they will include some combination of politics,

regulation, institutional frameworks, ecology or natural catastrophes. The most likely cause

of disappointing growth is for weak institutional frameworks to persist in several of our

target markets.


The knock-on impact of lower than expected economic growth on the banking sector

is high. Lower growth can translate into lower asset values with grave repercussions for

banks (including bank failures). On the flip side, during the late stages of boom cycles, low

growth could force banks to move into higher risk segments and to move down the credit

spectrum deepening the financial sector and broadening its reach. GCC banks had enjoyed

low competition and operating costs along with access to cheap funding resulting in high

profitability prior to the crisis. however, post crisis, slower economic growth has resulted in

lower foreign investment, change of regulations (e.g. introduction of price caps, limitation on

consumer lending, gradual easing of protectionist policies). These changes have forced banks

to increase their efficiency and sophistication in risk management and broaden their reach

towards subprime retail and mid-market corporate segments. This is not without risks as NPLs

tend to increase.

hot real estate sectors, soaring asset prices and currency appreciations in some of these

markets have all the signs of bubbles in the making. We see two potential threats here – a

commodities-led bubble leading to a global banking crisis causing serious losses for both

emerging and mature markets banks (unlike the recent crisis that had limited effect on EM

banks) or a Japanese-style early ’90s NPL crisis in some economies that halts growth for

many years. For example, China is especially vulnerable to the second threat, as the state-led

credit boom has caused rapid growth in banking asset values including a significant amount

of dubious quality. Similar real estate-led bubbles appear to be on the horizon in markets

such as Brazil and Turkey. The current inflationary environment can mask underlying credit

issues. For example, the low default rates observed in auto finance in Indonesia today are

driven by constantly increasing prices driven by inflation. Such growth is unsustainable and

will inevitably unwind, putting brakes on the growth.

Major discontinuities over extended time periods may also result in prolonged economic

and political instability negatively impacting the banking sector. Most of our focus

emerging markets are experiencing significant social, political and economic change

increasing the occurrence of upheavals such as civil strife, policy instability and sovereign

debt crises. Primary pre-requisites to growth include the continuing openness of markets

accompanied by sound regulation. The behaviour of the State and domestic regulators can

influence growth in a positive or negative manner. Since the crisis, regulators worldwide

have focused on ring-fencing local deposits and banking assets from claims abroad. Focus

has moved towards stronger corporate governance and the protection of local interests

in the operations of MNCs. The emergence of living wills and a general push towards

subsidiarisation is a growing trend across markets. Although this trend is clear in developed

markets, the “new normal” in emerging markets remains uncertain.


EFFECT OF LEGAL, REGULATORY AND POLITICAL FACTORS ON GROWTh – ThE CASE OF MORTGAGES

The growth of the mortgage market which is highly influenced by government policy on housing, legal structures around property rights and use of collateral and regulatory policy including around restrictions in mortgages.

• Government policy

In the US, establishing the government sponsored institutions, Fannie Mae and Freddie Mac, was the catalyst for the growth in mortgages. Similarly in Mexico, Infonavit serves a similar purpose, contributing to increased home ownership in the low-income salaried sector

• Legal structure

The clarity of legal process around property rights, particularly with respect to the rights of banks to repossess, is a “make-or-break” factor in the mortgage market. For example, in Saudi Arabia and Brazil, recent legal amendments are already bearing fruit with a significant uptick from very low bases in mortgage credit

• Regulatory policy

Central banks and regulators can moderate or exacerbate the growth of mortgage credit. Various regulatory tools have been used in the past to contain unsustainable growth, ranging from simple LTV restrictions to more complex balance sheet ratios. The establishment of the National Credit Regulator in South Africa is an example of a country taking pro-active action to ensure prudential lending

There will continue to be variations between markets in this area as the state and public institutions play varying roles in encouraging growth. We see “active” interventions markets such as Brazil, Egypt and Saudi Arabia through the build-out of legal structures, selected segment interventions in markets such as India’s with priority sector lending targets12 and gradually increasing involvement in countries such as Russia. Enabling growth in securitisation, pension investments and a long-dated yield curve also support growth of mortgages. Regulations can also limit growth. Some of the recent changes seen in GCC markets towards controlling consumer lending and curbing service charges are a case in point – while its impact remains unclear, banks will have to re-think their retail banking strategy in light of these new regulations.

12 Requirements for banks to lend % of balance sheet to “priority” or underprivileged or underpenetrated sectors.


Over the longer term, a range of external forces and critical uncertainties will shape the

future of the banking sectors across emerging markets. We have analysed the two primary

dimensions of volatility and regulatory policy. Stricter regulation is characterised by

increases in capital requirements, restrictions on capital flows and increased subsidiarisation

requirements. Based on this analysis, four plausible scenarios emerge:

ExhIBIT 16: ILLUSTRATIVE SCENARIOS FOR ThE FUTURE OF EM BANKING

LEV

EL O

F R

EGU

LATI

ON

STRICT

HIG

H

LOW

LENIENT

VOLATILITY IN FOCUS MARKETS

Protected safe havens

Closed“treasure chests”

Risky frontiersBenign land of opportunity

2

1

3

4

1. Benign land of opportunity

The “bull run” that we have seen in emerging markets has been one of relatively open

markets with low volatility. This is largely the scenario of the past with relatively high levels

of cross-border activity and expansion into many emerging markets.

2. Protected safe havens

This is a scenario where volatility remains low but central banks and regulators tighten

regulations through, for example raising minimum capital and funding requirements,

mandating subsidiary structures and ring-fencing capital. In this situation, cross- border

activity will decline as players focus on their core markets and onerous regulation

encourages “rent-seeking”. Consumers may be the losers in this scenario as margins may

come at their cost.

3. Closed “treasure chests”

In this scenario, high degree of regulation and high volatility would deter risk-averse

players. A move towards highly subsidiarised models with the growth of conglomerate

or bank-holding company type structures is expected. Large domestics funded by local

deposits are well-positioned in this world as their combination of local market knowledge

and branch-based models will serve them well.


4. Risky frontiers

This scenario is one where high volatility is accompanied by lenient regulation. This is

potentially the most unstable scenario, with high degree of cross-border activity expected

as foreign entrants rush towards a high-return market with low regulatory barriers. Expect

the emergence of more truly global players using a portfolio based approach to hedge the

high risks while still capitalising on high returns.

Stricter regulatory regimes are likely, for two primary reasons. First, the general trend

globally has been towards more restrictive norms post-crisis. Second, and more importantly,

past experience has made emerging markets regulators wary of foreign banks. During

times of crises, a common response of foreign banks typically has been to scale back. Many

foreign banks have cut credit or even shut down or sold their stakes in emerging markets.

IMF analysis indicates that foreign lending by global banks declined significantly in 2008,

contracting in the final quarter of 2008 at the fastest rate since records began 30 years ago13.

Some of this decline has been driven by pressure to lend more in their home markets after

accepting government bailouts but much has been purely to deleverage.

For example in India, all banks were growing their loan books at ~25% pre-crisis but this

changed rapidly in 2008. While state-owned banks kept growing credit albeit at a lower

pace, private banks more or less stopped lending and foreign banks reversed directions,

shrinking their loan books at ~10%. A stark difference between lending by foreign-owned

subsidiaries versus branches (or parent bank) lending has been observed in Latin America.

The stock of cross-border claims dropped by 20% in the last quarter of 2008, dramatically

reversing the 30% quarterly growth pre-crisis whereas lending by local affiliates of foreign

banks saw very gradual declines through 2008-09 and actually increases in some quarters14.

Recent developments appear to indicate a general move in the direction of stricter

regulation. For example, India and Indonesia have tightened their rules on cross border bank

activity. Brazil has already announced Basel 2.5 implementation for market risk following the

lead of developed markets. This makes scenarios 2 and 3 the most likely to develop. But the

picture is not clear-cut, so banks must be prepared for any of the scenarios.

13 Kamil and Rai, IMF (2009).14 Ibid.


SCALE MATTERS – ThE CASE OF BRAZIL AND ThE 2008 CRISIS15

The case of 2008 crisis in Brazil is an example of how scale impacts market concentration and stability of return in a volatile environment. After the failure of Lehman Brothers, increased risk concerns led depositors to move their assets into large institutions. Between August 2008 and January 2009, while total deposits in Brazil grew by 13%, deposits in large banks rose by 20%, and those in medium and small-sized institutions experienced declines of 11% and 23%, respectively. In a study by Banco Central Do Brasil, it was established that depositors ran from the smaller banks to the largest banks because they believed the later were too big to fail.

PERFORMANCE OF MID-SIZE BANKS IN BRAZIL

20% 6

10% 3

30% 9

40% 12

2005 2006 2007 2008 2009 2010 2011 (Mar)

00%

50% 15

FIDC Issuance of Credit Rights Investment Funds (R$ BN)

Medium Size Banks Loan Growth

Total Credit/GDP

Source: FITCh, Central bank

In addition, lowering investor confidence on small and mid-size banks resulted in a funding crunch. While many of these banks were successfully raising capital in international markets earlier, originating large volumes of loans and selling off their exposures to bigger banks through Credit Rights Investment Funds (FIDCs), this model fell through after the crisis. Due to higher risk aversion, large banks stopped buying the credit portfolios of their smaller competitors.

Overall, the lack of funding alternatives led to several small size banks going under and fueled the trend of consolidation in the banking sector. At the same time, big banks enjoyed stable investor and consumer confidence. Their deep branch networks and analytical sophistication in credit enabled them to be better originators of credit than their smaller competitors.

15 Banco Central Do Brasil, Fitch, Financial Times


6. REGIONAL VARIATIONS IN ThE NEAR-TERM

As banks embark on this journey in emerging markets,

how is the health of the sectors? What are the key

priorities of bank CEOs? In this section, we provide a

“temperature check” of our target markets providing the

near-term outlook.

We have compared the three year outlook for banking

sectors across key dimensions of capital, interest rate

environment and asset quality. We find that most markets

are extremely well-capitalised providing a good base for

sustainable growth. high growth, increasing capital flows

from low-return developed markets and increased EM

to EM activity has led to inflationary pressures and high

interest rates in a number of markets. Asset quality, may

worsen in many of the markets as banks move down the

credit spectrum – subprime in retail and SME in corporate.

KEY FOR INDICATORS IN TEMPERATURE CHECK

CAPITAL INTEREST RATE ASSET QUALITY LIQUIDITY

healthy Extremely well-capitalised banking system with good quality capital

Low/benign interest rate environment boosting credit growth

Good quality back book, low levels of NPLs in the short-term

Strong liquidity in the system

Poor

Low capital ratios posing significant concerns/ high risks

Very high interest rate environment potentially dampening demand

Poor quality of back book, rising NPLs

Poor liquidity ratios

BRAZIL

CAPITAL Low leverage; well-capitalised banking system allowing for sustainable growth

INTEREST RATES

high interest rate environment, export of quantitative easing leading to increased DM inflows into Brazil

ASSET QUALITY

Recent increase in delinquency rates in fast growing SME segment. Stable quality in Retail and Corporate

LIQUIDITY Adequate liquidity in the system, some recent reserve requirements hikes; concerns around high credit growth

KEY ThEMES ON BANK CEO AGENDA

• Growth quality: As banks look to capture the latent demand, they

will need to manage the quality of assets acquired. The industry is

facing a structural change in the composition of asset mix – towards

secured loans in retail and to SME in the corporate space

• Improvements in risk management/underwriting: In light

of recent developments such as the credit bureau/ availability

of positive credit information, banks are looking more towards

improving risk management frameworks

• Risks of high inflation/interest rates and lower investment

may affect demand. Credit exposure has increasingly become the

main source of revenue of most banks and asset duration has been

growing in recent years – this should make a slowdown more painful

MExICO

CAPITAL Large capital base with high and increasing BIS ratio

INTEREST RATES

Low-to mid interest rates with relatively stable outlook conducive to growth

ASSET QUALITY

Generally low NPLs but expected to increase as lenders move down the risk spectrum

LIQUIDITY Low loan-to-deposit (LTD) ratios, good liquidity in the system


• Growth capture: Banks have adequate capital and liquidity to

absorb credit demand, but need to build capacity. Millions of potential

customers reaching income levels viable for banking – including moving

MFIs and formal banking sector- question is how to get them, keep them

and nurture them as they work up the income ladder

• Capabilities upgrade: Focus on enhancements across the value chain

including improvements in client intelligence on the front end, stronger

risk management and process/IT platform upgrades at the back end

• Profits: Recent regulation changes and interest rate environment

has squeezed margins. Banks need to work out how to maintain

ROE in high teens – focus on cost efficiency and increasing risk

appetite particularly down the credit spectrum – potentially

enhancing returns


TURKEY

CAPITAL Strong capital cushions with most banks above 15% tier 1 ratios

INTEREST RATES

Elevated but dampened from historically high levels; some increases expected

ASSET QUALITY

Some easing of the increased NPLs seen during the crisis

LIQUIDITY Rapid growth in LTD ratios constraining the system


• Positioning for growth: Defining long term strategy to be best

positioned for the continued growth of the increasingly competitive

financial sector

• Funding challenges: Loan to deposit ratios have risen rapidly

over the past 10 years and now reached 100% for some players.

Mortgages currently funded by deposits, with much of the ALM risk

(e.g. prepayments, and some duration risk), to which Turkey needs

to develop a macro solution

• Sustaining profitability: Defining medium term strategy to sustain

profitability in a low and rising interest rate environment while

managing the impact of policy actions, such as the central banks 25

pct growth cap, recent large increases in reserve requirements

EGYPT

CAPITAL Solid capital positions above BIS/regulatory minimums; some banks extremely well-capitalised with high dividend payouts

INTEREST RATES

high interest rates – current and expected

ASSET QUALITY

Rising NPLs observed with the rise in social unrest; high levels

LIQUIDITY Strong liquidity positions across the industry


• Geopolitical uncertainties: Long-term effects of the Arab spring

on the Egyptian economy/financial sector are yet to materialise.

Uncertainties in geopolitics hinder long-term strategic planning and

require banks to be prepared for multiple scenarios

• Rising NPLs: Concern around the rise in NPLs due to social unrest

(on the retail side) and corruption charges in the corporate world

• Inflation: high inflation is still a concern here although it has fallen

from record highs of ~25%

RUSSIA

CAPITAL Surplus capital position particularly in the large state-owned banks

INTEREST RATES

high/rising interest rate environment – some credit growth due to rise from lower levels but dampening expected

ASSET QUALITY

high NPLs but comfortable coverage – gradual improvements expected

LIQUIDITY Varying levels of liquidity across the system with some (Sber) highly liquid


• Regulatory changes: Implementation of Basel II/III requirements

while fitting Russian market characteristics

• Capabilities upgrade: Focus on increasing sophistication of

approaches particularly in credit and underwriting approaches

• Local capital market development: Development of local capital

markets including developing long-term funding options

• Competitive landscape: Continued changes expected with

consolidation in the fragmented smaller banks and international

aspirations amongst the bigger players

GCC

CAPITAL Generally strong capital positions – some variations by market

INTEREST RATES

Significant quantitative easing led to low interest rate environment

ASSET QUALITY

Low NPLs for an emerging market in the past, recent increases, high concentration/interconnectedness

LIQUIDITY Long-term funding available, cash-rich


• Improving risk management: In particular, improving risk

governance, transparency and better defining and managing

strategic risk appetite

• Competitive dynamics: GCC is overbanked with more than 40

medium/big banks in an economy that is smaller than Spain. Unless

significant M&A activity happens, the market will be overcrowded

which will put pressure on margins and costs. Margin/pricing

pressure is already being felt in major markets such as Saudi Arabia

• Credit risks: While extreme liquidity stresses have receded, credit-

risk concerns remain in certain jurisdictions e.g. UAE

• Managing inflationary pressures is also a key concern


NIGERIA

CAPITAL Banks have improved their capital position but some concerns remain post-crisis recapitalisation

INTEREST RATES

high interest rates that may potentially affect demand

ASSET QUALITY

Nigeria has some of the highest EL ratios amongst emerging markets. At the same time, no hidden risks

LIQUIDITY Strong liquidity position with expected decreasing LTD ratios


• Industry structure: Increased M&A activity is expected as

consolidation continues post-crisis and increased foreign interest

particularly from other African banks

• Managing costs: Banks have some of the highest cost ratios seen

across our target markets. This is driven by the high infrastructure

costs and cost of doing business in Nigeria

• Improving risk management: While much improvement has been

made after the crisis of 2009-10 and subsequent clean-up by the

central bank, much still remains to be done to improve governance,

transparency and risk management making this an important issue

on bank agendas

SOUTh AFRICA

CAPITAL Developed country levels; some excess with potential for acquisitions, growth, dividends but increasing regulatory pressures

INTEREST RATES

Low-mid interest rate environment – no major risks

ASSET QUALITY

Effect of mispriced loans still drag on back-book; some slowing in NPL formation observed

LIQUIDITY Constrained liquidity position with increasing regulatory pressures


• Regulatory changes: Banks need to become compliant to new regulatory rules such as Basel III, particularly to meet Net Stable Funding, Liquidity Coverage and Capital ratios. Against this background there is a push towards retail, SME and Business Banking deposit gathering

• Cost management: All big four banks are faced with cost challenges resulting in major cost management programs

• Loan strategy rethink: The massive losses experienced in the past and new Basel III regulatory requirements are prompting a rethink of loan strategy using a more cautious approach then the explosive growth seen in the past

• Regional footprint: Banks are reviewing their African expansion strategy to follow the clients and establish efficient/integrated African operations to capture African banking opportunity (expected EP positive by 2016-17)

INDIA

CAPITAL Comfortable capital position in private sector banks but public sector (PS) banks need to raise capital

INTEREST RATES

Rising CB rates to control inflation may affect credit growth

ASSET QUALITY

Some concerns around asset quality in the near-term despite major restructuring in 2009, particularly in the SME sector and in PSU banks

LIQUIDITY CASA ratios already a concern – particularly in private sector banks


• Regulatory dynamics: RBI is an active regulator – this has increased bank regulatory costs, funding needs and affected credit growth. Recent changes are expected to limit the explosive credit growth e.g. real estate lending LTV limit of 80% and levying of affordability constraints. Priority sector lending and financial inclusion requirements will also affect bank operating models

• Competitive landscape: Impending new licenses could result in the entry of large corporates or other foreign banks reshaping the competitive landscape of the banking sector (draft regulation in consultation)

• Managing liquidity: Liquidity ratios will start to bite in a few years, and CASA and liquidity already a concern—loans are growing faster than deposits, even for SBI (largest bank)

INDONESIA

CAPITAL Strong capital/low leverage position – generally better capitalised than regional peers

INTEREST RATES

Generally high interest rate environ-ment. Recent credit growth driven by competitive lowering of loan rates

ASSET QUALITY

Some improvements expected but risks remain

LIQUIDITY Some concerns due to high loan growth and consumerism constraining funding


• Increasing competition: Foreign players are ramping up, smaller

players consolidating, mid-tier domestic players are becoming

increasingly competitive

• Loan downgrades: Outlook for higher NPL formations largely

depends on macroeconomic outlook. An adverse macroeconomic

scenario could lead to loan deterioration and substantial loan-loss

provision charges

• Sustaining profits: Margin compressions observed across the

industry driven by the high level of competition, downward loan

spreads in banks highly dependent on NII


ChINA

CAPITAL Relatively low capital ratios when compared to other emerging markets; but much improved from crisis/pre-crisis

INTEREST RATES

Managed economy – not volatile in the formal banking sector. The increasing relevance of the shadow banking sector and the high interest charged will make it increasingly difficult for the Government to manage and direct investment

ASSET QUALITY

Extremely high credit growth (state-led) in recent years. Although current NPL levels low, medium-term shock expected. Asset quality may additionally be masked though the unknown loan activity of the shadow banking sector

LIQUIDITY Adequate levels of liquidity in the system despite high credit growth


• Credit risks: The surge in lending during 2009 and 2010 has dramatically escalated credit crisis risk in China. historically low NPL levels appear to be unsustainable but outlook and timing of any correction is uncertain

• Leverage: Chinese banks have relatively low industry capitalisation levels. Tightening regulation (announced and impending) and expected future credit growth is expected to increase capital-raising in near/mid-term

• Managing costs: Efficiency ratios/operating costs have increased at a rapid pace and will need to be managed particularly as risks costs rise with the credit cycle

• Portfolio management: Banks are looking to more actively manage portfolio concentration due to high level of lending to the real estate sector and fears of the property bubble starting to deflate

• Managing cross-border flows and capital markets development also key issues

MALAYSIA

CAPITAL Capitalisation is adequate but not highly capitalised like some of the other EMs e.g. Brazil and Russia

INTEREST RATES

Low interest rate environment conducive to credit growth – despite recent (small) increases by the CB

ASSET QUALITY

Strong asset quality with the decline in NPL ratios in recent years – not expected to decline further

LIQUIDITY Relatively high LTD ratios


• Funding challenges: Gross national savings remains low and retail

deposits remain flat as a portion of total. Deposit growth is trending

lower and LTDs are increasing and expected to continue growing

• Sustainable growth: As the market matures, sustaining growth is

a priority. Additionally regulatory moves such as lower LTV limits,

higher RWA for property loans and credit card regulations make the

market more challenging

• Regional aspirations: Increased consolidation may be expected

and increasing interest in regional expansion although many

challenges remain


7. IMPERATIVES FOR BANKS IN EMERGING MARKETS

So how should banks strategise in the light of this unprecedented shift and prevailing

uncertainties? We have broken down the problem into two parts. First, we analyse the

critical success factors for multi-country operations in light of the observed business model

options. Then we lay out the important levers for optimising local operations within each

market particularly in the context of capturing the massive retail growth opportunity.

7.1. MANAGING MULTI-COUNTRY PORTFOLIOS

The emerging markets growth story has not been missed by the major players. Several

markets have been deluged with new entrants. Turkey, for example, saw ~40 financial

services companies enter the market, including 13 foreign banks, in just five years (2005-10).

however, many banks have expanded without a clear strategy. As banks try to capitalise on

the retail growth opportunity across emerging markets, they will need to build a robust multi-

country management framework. We have categorised players along two axes – their degree

of integration and level of specialisation.

First is the degree of integration across geographies for multi-national banks. This will drive

the extent to which players can achieve economies of scale. At one extreme are the fully

integrated players that can focus on global operational excellence and aim to consolidate

their balance sheets to a large extent. These banks may rely heavily on wholesale funding.

On the other end are banks with loosely affiliated local operations with considerable

variation in performance across countries, high local expertise and eroding cost models.

Second is the degree of specialisation. As emerging market banking sectors mature, we

expect new client segments and their service requirements and products to become

more sophisticated and competition to intensify. Therefore the broad universal models of

many emerging market banks will only be defensible for the largest banks in the emerging

markets. Specialist competition is increasingly adding competitive pressures particularly in

markets with increased data transparency and access to wholesale funding. Choosing their

“competitive spheres” will be important for banks. The set of products or segments that

banks choose to play in will have implications for the operating model.

Based on where leading players stand across various markets, four business models can be

observed within the above framework as shown in Exhibit 17.


ExhIBIT 17: BUSINESS MODELS FOR MULTI-COUNTRY PLAYERS

LEVEL OFSPECIALISATION

DEGREE OF INTEGRATION

High/product or customer focus

Low/fullservice

Localised Select scale/scope economies

The “Rising specialists”

The “Multi-locals” The “Synergizers” The “Globals”

Fully integrated

MODEL KEY CHARACTERISTICS

Globals • Local business able to “plug into” global product factories, operations and shared services

• Sophisticated with high level of centralisation as bank pursues growth and scale

• Focused around global functional excellence and maximising economies of scale

• Manages capital and balance sheet flexibly across countries

• Strong central treasuries focussed on minimising global funding costs in the wholesale markets

Synergizers • Model covering multiple markets run usually as a portfolio of banks

• Often grown as regional/country models that can pick up and adapt to local market variations

• Some players choose to run them a set of loosely affiliated local centres, often multiple brands

• Mix of branch/subsidiary models varying by market, level of integration with global also varies

• Some key areas for shared services to drive operational cost reduction

• Cross-border funding optimisation through central treasuries

Multi-locals • Conglomerate or holding company structures

• Emphasis on local decision making and entrepreneurship

• Functions as a set of loosely affiliated local centres, often multiple brands

• high level of variation in performance; difficult to benefit from economies of scale

• Limited to no funding synergies on the sub-holding level – group centre with varying ability to function as buffer on

funding and capital (dependent on extra levels available)

Rising specialists • Players with specialist focus such as card specialists, payments processors, retail brokerages

• higher funding costs (e.g. for credit operations) to their universal bank competitors are neutralised through

specialised knowledge and lower cost bases

• Payment operators exploit lower central operating costs (leveraging distribution partners), existing third party

infrastructure (e.g. mobile) and global networks


In deploying the above models, banks will need to frame their strategy around the expected

high growth environment in emerging markets and prepare for the intrinsic volatility levels.

We have identified four strategies that are critical for the success of multi-country emerging

market banks. Within each of these strategies, we elaborate on the specific implications for

the business models above:

• Avoid fragmented bets

To ensure that long term investment can be justified; banks will need to pick a portfolio of

markets to focus on. Fit with overall strategy should drive target market selection subject

to external constraints, such as market attractiveness and legal or regulatory constraints,

as well as internal capabilities. The management framework and its cohesiveness to drive

performance across the individual markets are key to avoid the traditional conglomerate

discount of the Global Universal Banks. This is especially relevant Multi-Locals looking to

expand – a coherent strategy with a clear understanding of the local market is necessary

before expansion. Globals will need to reassess their footprint and focus their strategies

on key markets using a long-term view.

• Be clear what your sustainable advantage is and don’t underestimate local players

Domestic players in the private sector are often very successful with strong local market

knowledge and alliances to secure an information advantage. For example, banks in Brazil

have teamed up with mobile providers, retailers and construction companies to secure a

broad information advantage in the market. Domestics should not be underestimated as

the local information advantage secures significantly higher profit margins vis-à-vis the

international competition. In markets with regulations that favour domestic players, their

competitive advantage is even stronger.

• Develop scalable “killer apps”

The use of innovation with scalable models has allowed specialists to build large

operations across multiple similar markets. In some cases, innovative business models

allows for entry into markets with regulatory barriers and internal bureaucracies. BNPP

has successfully done this with Cetelem.

• Invest for the long-term

Playing successfully, particularly in the retail banking space will often require significant

investment in building outreach and penetration which may not reap immediate benefits.

This is most relevant for the Globals seeking to have a large presence in key markets such

as India and China. Domestic players are quite aggressive in building out deep distribution

networks. Entry without a systematic plan for gaining scale will naturally tend to put foreign

players in a weak position vis-à-vis domestic giants – eventually a losing game in long run.

In summary, we advocate a focused and committed strategy when investing in emerging

markets for the long-term.


7.2. OPTIMISING LOCAL OPERATIONS

Retail banking will rapidly become more sophisticated and competitive as it grows. Players

will need to get smarter, more nimble and better at what they do to capture the opportunity

and stay ahead of the market. We have identified eight levers that banks can use to

optimise the value they extract from their retail banking operations.

ExhIBIT 18: KEY SUCCESS LEVERS FOR LOCAL OPERATIONS

Invest in customer dataCUSTOMER

PRODUCT

CHANNEL

ORGANISATION

OPERATIONS

Increase granularity in customer segmentation

Needs-based tailoring of value proposition and delivery

Innovation in serving under/un-banked and higher risk segments

Break down the barriers between retail and corporate

Manage your talent

Run the bank at highest attainable e�ciency levels

Upgrade risk management infrastructure

1

2

3

4

5

6

7

8

1. INVESTMENTS IN CUSTOMER DATA: COMPETITIVE ADVANTAGE ThROUGh BETTER CUSTOMER INSIGhTS

The lack of organized and trusted data in emerging markets means that players can gain an

edge by owning and maintaining proprietary customer intelligence. Investments should be

made to better record and mine proprietary databases as well as into collection of sufficient

primary research insights on prospective customers. Partnerships can be an effective way of

achieving this goal but will require high energy levels from senior management to manage

over the medium to long-term.


2. GRANULARITY IN CUSTOMER TARGETING: “SUB-SEGMENTATION” DRIVING GO-TO-MARKET STRATEGY

Players today bucket customers into fairly broad segments, such as high-net worth, mass

affluent and mass. This has led to many players adopting a ‘one-size-fits-all’ approach within

each segment. Although this has been sufficient when scratching the surface on retail,

there is an increasing need for smarter sub-segmentation. First, intense competition at

the top of the pyramid will force players to differentiate. For example, our research on the

affluent segment highlights a wide variation of price sensitivity and of the importance of

convenience to hNIs that players can seek to exploit. Secondly, as banks expand down the

pyramid, the target customer profile will become more varied and the same products and

marketing approaches will not work. Since sub-segmentation ultimately drives the product

and channel strategy, its design should be driven with this objective, starting right from the

gathering of customer insights.

3. NEEDS-BASED TAILORING OF VALUE PROPOSITION AND DISTRIBUTION ChANNEL

Banks today have a highly transactional relationship with the customer. They tend to push

pre-packaged products to customers often with limited fit to needs. The flow of customer

information and feedback to management is limited at best and mostly non-existent. This

restricts banks’ ability to design products that fit and evolve with the changing needs

of target sub-segments. Banks can use the segmentation approach discussed above to

generate quantum improvements in value proposition design. While need-based product

design will drive top-line gains, optimising delivery mechanisms (from a client and cost

perspective) can directly translate customer insights into bottom-line gains. This must

include streamlining of the vast branch networks of domestic giants to ensure that they

remain a source of profitable growth without undue costs.


4. INNOVATION IN SERVING ThE UNDER- AND UN-BANKED LOWER INCOME AND hIGhER RISK SEGMENTS

As discussed above, the top segments of the wealth pyramid in some emerging markets are

becoming saturated. It will be imperative for players to move down the wealth pyramid to

realize continued growth. This can be achieved by building innovative scalable propositions

to reach the fast-growing mass market and low income segments. These segments may be

price sensitive in many markets and economies of scale can enable players to achieve the

required low unit cost base. The increasing use of technology and the ubiquity of mobile

phones provide opportunities in this context. Safaricom’s M-Pesa payments product in

Kenya is an example of how innovation can drive transformational changes on both the

consumers and the industry16. Such innovation can also be used to build customer loyalty in

low income segments, which will allow banks eventually to up-sell core banking products as

clients move up the income pyramid.

Additionally, tapping high risk and underserved segments, such as SMEs, will also require

innovation. An emerging example of this in markets like Turkey and India is the growth of

asset-based lending specialists using gold as collateral. India’s formal gold loan market is

estimated to be growing at 30-40% but due to the volatility of this asset the loans tend to be

of short tenure usually used to fund working capital requirements.

5. BREAK DOWN ThE BARRIERS BETWEEN RETAIL AND SME/CORPORATE BANKING UNITS

Most incumbents in these markets, having evolved from traditional corporate banking

models, display poor communication between the retail and SME corporate banking arms

and also between acquired entities. Active collaboration between retail and SME/corporate

banking will lead to increased cross-sell and provide alternate channels to reach untapped

segments e.g. affinity marketing for credit cards and retail employee accounts through

corporates. Exploiting the SME corporate client base for retail requires segmentation,

adjustments of incentives, clear rules of engagement and a defined value proposition such

as international finance, export products or wealth building options.

16 M-Pesa has grown to command ~9-10% of Safaricom’s revenue and is now enabling banks to increase their outreach many-folds through branchless channels.


6. MANAGE YOUR TALENT: LONG TERM CAREER-BASED TALENT MANAGEMENT STRATEGY

With growth, talent management become increasingly important. high churn rates

for frontline staff and long recruiting cycles for senior staff need to be minimised by a

business-driven talent strategy, appropriate long term performance incentives and strong

professional development programs. Countries with a paucity of high-quality talent,

such as Egypt, Nigeria and Saudi Arabia, need an even stronger focus on this than other

markets. Foreign players can achieve an edge by reallocating resources across international

operations to serve local needs.

7. RUN ThE BANK AT hIGhEST ATTAINABLE EFFICIENCY LEVELS: IMPROVE QUALITY OF OPERATIONS, ThE BACK OFFICE AND INFRASTRUCTURE

Winners will need to maximise scale benefits by running a tight shop in the back office. The

move towards scalable, automated systems will be inevitable, particularly to reduce costs and

minimize labour intensive processes. While embarking on this move, most emerging markets

players, unencumbered by legacy systems, have a unique opportunity to leapfrog outdated

technology and build streamlined nimble systems. Establishing strong data management and

analytics capabilities will drive fact-based strategy and decision making.

The other area that requires significant investments is process management. This is

required both in major transformational programs and in optimising existing operations

and management practices. Execution risk is a major point of failure in many emerging

markets strategies. Key success factors include aligning front-line KPIs to reinforce

implementation, training to ensure strategies are followed through and implemented,

trigger and failsafe compliance and performance management mechanisms to ensure

that performance management and compliance indicators are not systematically

overridden to ensure that the organisation can learn from past experience.

8. UPGRADE RISK MANAGEMENT INFRASTRUCTURE

Last but not least, winners will need a robust risk framework to help them grow at the

right pace. The risk framework should be built to ensure growth at the “right” pace – not

too fast such that the risks are not understood or controlled and not too slow such that

opportunities are lost. Managing risks needs to become central to growth strategy. It is

more critical in developing markets due to the inherent volatility and uncertainty in these

markets. At the group-wide level, banks will need to set risk appetite levels and build a

robust risk management infrastructure in order to monitor and mitigate emerging risks.


CONCLUSION

In summary, we believe that there is significant potential in emerging markets banking in

the long-term. In order to capture this opportunity, banks must buckle down and map out

their strategy for the long-term. We recommend a portfolio approach of “select scale” where

players choose their focus markets and invest for the long-term. Within each market, players

need to make improvements across the value chain as emerging markets tread the path

to maturity.



ABOUT THE AUTHORS

GREG RUNG

Greg Rung is a Partner in Oliver Wyman’s Dubai office. [email protected]

MIChAEL WAGNER

Michael Wagner is a Partner in Oliver Wyman’s New York office. [email protected]

ChAITRA ChANDRASEKhAR Chaitra Chandrasekhar is a consultant in Oliver Wyman’s New York office. [email protected]

SPECIAL THANKS TO

Evren Ucok for his support on the realisation of this report.

Copyright © 2011 Oliver Wyman. All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect.

The information and opinions in this report were prepared by Oliver Wyman.

This report is not a substitute for tailored professional advice on how a specific financial institution should execute its strategy. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisers. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages.

This report may not be sold without the written consent of Oliver Wyman.

Oliver Wyman is a leading global management consulting firm that combines deep industry knowledge with specialised expertise in strategy, operations, risk management, organisational transformation, and leadership development.

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