The global banking sector has made some progress over the past year towards stabilising after the financial crisis. Banks have launched numerous initiatives to improve capital efficiency, revenues, and costs. However, the impact was not reflected in 2011 earnings, due to the combined impact of low interest rates and tightening capital requirements. Further, the sector faces some difficult choices going forward as it strives to improve performance and regain the confidence of investors and society. Amid tighter regulation, shifting customer dynamics and macro volatility, the search for a sustainable model goes on.

More capital, but not yet a sustainable model

Substantial increase in capital base

Banks have made significant efforts in the recent period to stabilise their balance sheets, lifting average Tier 1 ratios to 11.7% in 2011, compared with 11.4% in 2010 and 8.2% in 2007.

Since 2007, the Tier 1 capital of the sector increased by $2.0 trillion, a rise of 57%. In the same period, assets grew by 25% ($17 trillion) leading to lower levels of leverage. In 2011 those trends continued, but at a slower pace.

Portfolio risk positions and management of risk-weighted assets (RWAs) improved. RWAs increased less than total assets.

Banks have since 2007 increased deposits by an impressive $17 trillion (32%), driving a four-year trend of declining loan-to-deposit ratios, which averaged 85% in 2011, compared with 97% in 2007.

Performance has deteriorated

In last year?s global banking sector report, we discussed the need to improve along three vectors: capital efficiency, revenues, and costs. While banks made efforts across all three vectors over the past year, the changes were not reflected in profitability. That is partly because of the challenging macroeconomic environment, which offset the positive effect of banks? initiatives. A full performance transformation may take several years. Capital efficiency deteriorated slightly. Notably, the ratio of off-balance-sheet to on-balance-sheet financing decreased, as the ratio of securitised loans and non-financial corporate bonds dropped by 1 percentage point to 29%. Revenue growth lost momentum: Global revenues grew by just 3% last year to $3.4 trillion, compared with 9% from 2009 to 2010, as recovery of risk costs declined and revenue margins deteriorated on average by 11 basis points. Cost-to-income ratios rose while cost to- asset ratios were stable. The sector?s cost base in 2011 jumped 5% to $2.5 trillion.

Many banks didn?t earn cost of equity

Global banking ROE fell by 0.8 percentage points to 7.6% in 2011, well below the 10-12% average cost of equity. Average earnings fell by 2%.

Three regional variations

US: a tough road ahead: US banks improved balance sheet positions, largely driven by regulation. Average Tier 1 ratios were 12.7% in 2011, compared with 7.5% in2007, while RWAs fell by 2%. Still, moderate revenue growth, declining margins and increased costs (cost-to-income ratio of 68% vs 60% in 2010) suggest US banks face significant challenges to long-term profitability. US banks earned an average ROE of 7% in 2011.

Europe: significant risks: Despite an increase in average Tier 1 capital of 0.4 percentage points to 11.7% last year, risk in the European banking system has increased. Leverage remains high, and many European banks have yet to realise loan book risks. Southern European banks remain reliant on the drip feed of ECB and emergency funding. There was little progress on earnings. In Western Europe, revenues declined by 1%, and remain 16% below pre-crisis levels. Costs meanwhile rose. European banks on average earned a ROE of 0% (5% excluding the troubled peripheral countries).

Emerging Asia (excluding Japan and Australia): continued growth, though slower and more volatile: Emerging Asian banks have maintained sound capital and stability ratios and will to account for more than 39% of global revenue growth. However, average ROE may drop by 3-4 percentage points from the current 17% because of increased regulatory demands in some markets, as well as declines in asset quality and shifts in consumer dynamics. Emerging Asian banks in the past year lifted Tier 1 ratios by 0.2 percentage points to 10% (slightly below the global average). However, this may not be sufficient in the medium term given the need for growth capital, with emerging Asian banks estimated to require more than $1 trillion in new capital through the coming decade. With downward pressure on ROE and over 75% government ownership (and governments likely to limit capital injections in this environment), attracting private capital will become a priority within 2-3 years. This could necessitate another round of business model innovation to bolster ROEs and policy action in some markets. China faces some specific challenges. Increased bad loans (mainly to local governments and SME) and slower economic growth expectations of about 8% give rise to concerns. In addition, China needs to manage the smooth transition from a heavily directed growth model to a more market-driven economy.

Investor confidence remains low

Although regional differences are significant, investor confidence in the banking sector fell globally. Average price of insurance against default in the credit default swap market of 124 banks exceeded 370 basis points in the past year, the highest level on record. Mid-2012, bank stock market valuations were at very low levels, with an average price-to-book ratio of 0.8 in developed markets and 1.5 in emerging markets, compared with 1.0 and 1.9, respectively, in 2010. Some two-thirds of banks in developed markets and over 40% in emerging markets traded below book value.

Earnings headwinds may increase

Regulation has become more complex and burdensome

At the heart of the reforms are new rules for capital, liquidity, funding, and OTC derivatives. In retail banking, a wave of consumer protection rules is being implemented globally. In addition, the pendulum is swinging towards more regulation, driven by recent events such as the LIBOR fixing scandal and the widespread loss of faith in the sector?s conduct. The impact of regulation on bank profitability will be significant. In retail banking in Europe?s largest economies we estimate that 2010 ROE would have been 6% instead of 10% if all the regulation in the pipeline was already applied. In capital markets globally, we estimate that 2010 ROE would have been 7% instead of 20% under the same circumstances. The risk of over-regulation has increased. It will become more challenging for banks to raise capital and funding which is sufficient to meet both new regulatory requirements and support lending growth.

A trend-break in sector growth

For the past three decades, the regulated global banking sector grew faster than underlying national economies. This trend has come to a halt. Banking penetration in North America fell to 6.3% in 2011, from a high of 7.8% in 2007, and is not expected to reach pre-crisis levels before 2020. In Western Europe and emerging markets, banking penetration is expected to remain flat around the current rates of 4.5%and 4.9% respectively. Still, fundamental demand trends remain intact, fueled by the natural financing needs of expanding economies. Rising global infrastructure investment, growing international trade and the needs of ageing populations may constitute a base on which to build profitability in the longer term.

What is the size of the performance challenge?

In order to achieve 12% ROE, cost-to-income ratios would be required to drop to 46% in Europe, from an average of 68% in 2011 and to 51% in the US, from 68%. Banks have already initiated various mitigating actions. The magnitude of this challenge, however, highlights the need for a fundamental transformation.

What might boost earnings?

In the medium term, two potential developments could give earnings a boost: interest rate recovery and sector repricing. Still, those changes by themselves are unlikely to return ROE to acceptable levels.

Interest rate recovery could boost margins. Our simulations show that a 100 basis point increase in underlying rates would boost ROE by 1 percentage point in the US and 0.6 percentage points in Europe. The benefit is greater in the US because interest rates and loan-to-deposit ratios are currently lower than in Europe, creating a relative advantage in any rise.

If banks continue to earn returns below their cost of equity, investors will be reluctant to commit significantly more capital. Lending capacity will grow more slowly than demand and result in structural repricing, if not delayed by market structure interventions.

One key reason why many under-performing businesses have remained in the market is the $1.7 trillion in direct support (capital injections, assets purchases and state lending) injected into the global banking system.

The triple transformation

For many banks in crisis hotspots like peripheral Europe, immediate survival will remain a predominant focus, with the priority being to secure funding, replenish capital and restructure assets. The sector as a whole must look beyond survival and plan for the future. Waiting for cyclical change may not be sufficient. Banks should aim high, fundamentally transforming their economics, business models, and culture: what we call a ?triple transformation?. Many banks require fundamental transformation of business models.

Banks, rightly or wrongly, are widely viewed as primarily responsible for the troubled state of many economies. Recent scandals have pushed their reputations to new lows and caused some stakeholders to question the underlying culture and values of banks. Banks should view cultural transformation as a strategic issue, not a public relations problem. They should examine their cultures carefully across four dimensions to ensure they are fostering value creation: balancing the interests of shareholders and society as a whole, creating value for customers, ensuring the soundness of internal processes, and influencing the mindset of employees. This will not only increase safety and soundness, but will restore public trust, spur customer-oriented innovation, and form a strong foundation for long-term sustainable growth.