eastern european banking: time to shift gears

Eastern European banking: Time to shift gears

December 2012

Krisztina Bákor

Miklós Dietz

Attila Kincses

Irene Shvakman

Banking and Securities (Europe)

Contents


Introduction and summary 1

Eastern European banking: 2011 status and outlook 1

Strong growth is expected to continue following solid progress in 2011 1

Buffeted by structural volatility 2

A year of contrasts: Performance continues to diverge in 2011 and 2012 3

Rapid technological and behavioral changes compound the challenges 4

Accelerated transformation is now imperative 5

Portfolio restructuring and improving the regional governance model: Less progress 5

Innovation: More important than ever 6

Spotlight on the largest markets 10

Bulgaria: Low base rates have reduced margins 10

Czech Republic: The benefits of low loan-to-deposit ratios 10

Hungary: Ongoing regulatory uncertainty 10

Poland: An island of stability, but not without risks 11

Romania: Continued lending growth even after the bubble 12

Russia: Growing state-owned giants 12

Slovakia: Getting a handle on risk and costs 13

Ukraine: Still recovering from the binge 13


Introduction and summaryLast year in “Eastern European banking: Moving toward a new paradigm”1 we focused on three main themes. First, we reviewed the “performance paradox” of the last decade, which saw limited value creation among the group of leading banks despite a golden era of growth and market-level profitability. Second, we looked at the macroeconomic trends that are likely to shape the economics of banking in the region in the next decade, including fundamental drivers such as low savings rates and demographic decline, and segment-specific trends such as urban, trade, and infrastructure development. Third, we suggested to banking groups that to benefit from these trends, they should reinvent their business models using four key levers: portfolio restructuring, changing governance models, developing differentiated approaches to priority segments, and innovating in their operating models.

This year’s report examines market developments in 2011 and, where data exist, so far in 2012, and provides our updated outlook for the Eastern European banking sector. We discuss how the market has seen a quick rebound in revenues but has experienced volatility and divergence in performance. We also make an assessment of the region’s banking business models, showing that improvements undertaken so far have taken the sector in the right direction but are not deep enough to meet its challenges. We argue that it is time for banking groups to accelerate their transformation efforts and, where necessary, consolidate their subscale operations. As in last year’s report, we conclude with a review of the largest banking sectors in the region.

Eastern European banking: 2011 status and outlookIn 2011, the Eastern European banking sector’s rebound continued, mainly driven by recovering volumes (up 14 percent from 2010 to 20112 ) and the turn in the risk-cost cycle after the 2009 peak (15 percent decline in 2011 from 2010). Although there was some margin deterioration (a 13 basis points (bps) decline in 2011), revenues on a post-risk-cost basis grew 20 percent. This momentum has continued in 2012, though at a somewhat slower rate. Preliminary figures suggest that volume growth for the year will be around 8 percent. With stable

margins and continuing risk-cost recovery, growth in revenues on a post-risk-cost basis for 2012 could reach 12 to 15 percent.

Two factors continue to shape the story of the Eastern European banking market. First, Eastern Europe has immense scope to catch up from being the poorest region in the world in terms of financial wealth relative to nominal GDP—below even Africa. Second, its population is aging at a rate similar to that of Western Europe. These two dynamics are fundamental to the banking sector’s performance and will continue to drive results going forward. On one hand, extremely low financial penetration levels all but ensure brisk revenue growth. On the other hand, the low penetration levels and unfavorable demographic trends make the region dependent on external capital, resulting in extreme market volatility. Market capitalization of the sector still remains well below its 2007 peak, and the region has the highest percentage of banks worldwide with a price-to-book value (P/BV) below one. Under such circumstances, it is no wonder that a high degree of performance diversity persists among market participants. Consequently, Eastern Europe is a region where strategy truly matters.

Below we examine in detail the sector’s growth, volatility, and divergent performance. We also discuss how changes in technology and consumer behavior are affecting the sector.

Strong growth is expected to continue following solid progress in 2011Revenue after risk cost grew solidly in 2011 (20 percent), continuing the rebound of 2010 (10 percent). The region quickly recovered after the trough of the financial crisis, and outgrew other regions in revenue after risk cost from 2009 to 2011, with a compound annual growth rate of 15 percent, compared with the world average of 7 percent (Exhibit 1).

The fundamental drivers of the above par growth have been Eastern Europe’s high real GDP growth (3.0 percent per annum versus 1.7 percent per annum in Western Europe between 2009 and 2011) in combination with the gap in the region’s level of banking penetration compared with other regions (as shown in Exhibit 1). The region presents very low retail-banking volumes relative to disposable income (100 percent compared with the 373 percent world average) and

1 The report “Eastern European banking: Moving toward a new paradigm” is available at the McKinsey Global Banking Pools website: solutions.mckinsey.com/globalbankingpools. For a condensed version of the report, see Miklós Dietz, Adam Homonnay, and Irene Shvakman, “What’s ahead for banking in Eastern Europe,” February 2012, mckinseyquarterly.com.

2 Regionalgrowthratesarequotedinfixedforeign-exchange-rateterms.

2

corporate volumes to GDP (56 percent versus the 99 percent world average). In addition to these low penetration levels, risk costs are expected to move down from current high levels, which may provide further support for growth.

Profitability in the Eastern European banking sector also continued its recovery from its low point in 2009. Return on equity (ROE) improved across the region: in 2011 the average ROE in Eastern European banking was 10.0 percent, compared with 2010’s 7.5 percent.

Based on the strong fundamentals, Eastern Europe is likely to stay one of the fastest-growing banking regions in the world. Preliminary 2012 results support this positive outlook. The further growth in banking revenue will be mainly fueled by volume expansion (especially by personal- finance asset growth), partially offset by tighter margins.

Buffeted by structural volatility The region’s dependence on external capital means that volatility will remain a structural feature of the region’s economy. Thus, weaknesses in Southern Europe or elsewhere have negative consequences for the region. During 2011, average credit-default-swap spreads of Eastern European

countries3 increased by around 170bps (up to approximately 270 bps in certain countries). While spreads have shrunk during 2012, they clearly have the potential to open up again.

A slowdown in Eastern Europe as a reaction to South European developments is already visible. Macroeconomists have adjusted growth forecasts for the region: the expected average nominal GDP growth for the next three years has decreased by about 1.1 percent per annum.

Market capitalization and price-to-book valuations provide further evidence of the sector’s extreme volatility. The market capitalization of the banking industry in Eastern Europe has endured the most pronounced swings of any region worldwide. The industry’s market capitalization recovered quickly following the collapse in 2008, when it fell 75 percent within a year. After a rapid rebound of approximately 250 percent during 2010, market capitalization fell abruptly once again, down by around 30 percent through the end of 2011. Market capitalization increased only modestly during 2012, reaching $170 billion in November (Exhibit 2).

As a result of cautiousness in capital markets, the Eastern European banking sector experienced the largest fall in

3 Average of Bulgaria, Czech Republic, Hungary, Poland, Romania, Russia, and Slovakia.

Exhibit 1 The growth of the Eastern European banking sector is driven by low penetration. 2011 ESTIMATES

Revenues after risk cost, 2009–11 CAGR1

$ billion, 2011 fixed FX2 rate, % Revenues after risk cost/GDP, 2011%

World: 7%

Japan –6.6%

Western Europe –1.3%

Rest of Asia 9.4%

North America 9.5%

Latin America 11.0%

MEA3 12.0%

Eastern Europe 14.8%

China 37.0%

6.3%

Latin America 7.1%

China 7.4%

World: 5.1%

Eastern Europe 2.7%

MEA3

Rest of Asia

Western Europe

Japan

North America

The region’s rebound was strong after 2009… …however, the gap in penetration is still high.

1 Compound annual growth rate.2 Foreign exchange.3 Middle East and Africa.

Source: McKinsey Global Banking Pools

3.8%

4.3%

4.3%

4.4%


Eastern European banking: Time to shift gears 3

P/BV ratios of any region, and as of November 2012 the region has the highest percentage worldwide of banks with a P/BV below the value of one—74 percent versus a 61 percent world average. This means that three out of four Eastern European banks will not be able to earn an ROE higher than their cost of capital, posing a huge question mark about the sustainability of their business models despite the growth potential of the region.

A prolonged bailout of troubled EU countries is negatively affecting the region, and a eurozone breakup could hit the region particularly hard. It would not only reduce trade significantly but would also seriously hurt funding sources for banks. According to our simulation, a eurozone breakup would cause three to four years of lost revenue growth for the region’s banking sector.

A year of contrasts: Performance continues to diverge in 2011 and 2012Last year we expressed a view that performance of the banking sectors in countries across Eastern Europe would diverge. We clustered Eastern European countries

and their banks into groups based on macroeconomic conditions and banking-sector vulnerability. This performance differential among the groups has been borne out, with a growing divergence in performance between the “performing” and “constrained” markets, as seen in a widening gap in ROE (Exhibit 3).

The average ROE of the top-performing countries (Russia, Poland, Czech Republic, and Slovakia—ranging from 11 percent to 15 percent in 2011) was significantly higher than the average ROE for the constrained markets (Bulgaria, Hungary, Romania, and Ukraine—with ROEs ranging from –5 percent to 6 percent). In addition, while ROE results of the first group improved significantly, performance of the latter group stagnated, resulting in a widening gap. It is important to underline that this divergence is occurring due to accelerating growth of the best-performing countries, rather than due to deterioration in the performance of the constrained markets.

As far as financial health,4 however, the picture is mixed. The constrained markets are struggling to deleverage and reduce their loan-to-deposit ratios to healthy (approximately 100

What’s next?

Bottom:largest collapse(decline of ~70%)

Market capitalization of top Eastern European banks1

2000 = 100

2012Nov

20112010200820072000

Exhibit 2 The roller coaster continues in banking-asset valuation.

1 Sample of 10 listed Eastern European banks with exhaustive market-cap data between 2000 and 2012, plus VTB Bank (Russia)and PKO Bank Polski (Poland) from 2007.

Source: Thomson Reuters; McKinsey analysis

ESTIMATES

Bottom:second-largest collapse again(decline of ~30%)

Top:fastest recovery(growth of ~2.5x)

Top:fastest-growing region(total growth of ~20x)

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

2,600

4 Definedasacombinationofloan-to-depositandTier1capitalratios.

4

percent) ranges, revealing continued funding difficulties. However, these markets actually overtook the performing markets in terms of Tier 1 ratios, driven by needed capital injections, but the bolstering of capital reserves undertaken by the constrained-market banks may have contributed to their poorer performance during this period.

The increasing divergence of performance is not just at the country level. Indeed, there are large value-creation differences among the largest banking players in the region.

Rapid technological and behavioral changes compound the challenges The banking executives we surveyed agree about the importance of technological adaptation as the most influential factor shaping the future (Exhibit 4). Recent technological changes, however, present a potential threat to the Eastern European banking sector’s economic pillars of high margins and low cost, features that have been built up in a market that has a different structure and consumer profile from that of Western Europe. A comparison between Poland’s and the United Kingdom’s retail markets is illuminating. While penetration of financial services is similar, the average financial asset base held by individuals in Poland is only 1/12 that of the United Kingdom. Like other Eastern European banking sectors, Polish banks compensate for lower-average

client volumes through lower operating costs (Poland’s costs are one-third those of the United Kingdom) and high margins (three to four times higher in Poland than the United Kingdom). Consequently, Poland’s banks earn a retail ROE above the level of UK banks.

Why might technology pose a threat to Eastern European banks? Because the market’s high margins attract all sorts of new entrants—including technology-enabled online and direct attackers as well as nonbanking players. These new entrants are gradually pushing down margins. At the same time the region’s cost advantage is eroding rapidly due to the global pricing of many elements, such as IT systems, as well as rising wages.

Changes in customer behavior also drive technological advances. Increasing numbers of customers demand online solutions—a 20 percent decline in branch visits is expected over the next five years in the region along with increasing automation to align with customer desires (which could result in a 10 percent decline in branch staff numbers over the same period). In addition, Eastern European youth are catching up to their Western European peers in Internet usage (above 95 percent in the 16-to-24 age group in certain countries, such as Poland). Banks must adjust their service offerings to accommodate these new needs.

Exhibit 3 An increase in diversity is reflected by the widening return-on-equity gap between the ‘performing’ and ‘constrained’ markets.

18

16

14

12

10

8

6

4

2

0

–2

–420112010200920082007

Slovakia

RussiaPoland

111009082007

151050

–5

–30

UkraineRomania

Hungary

20

Bulgaria

20111009082007

Market return on equity (ROE)%

Market ROE %

Market ROE %

ESTIMATES

“Performing”

“Constrained”

0

5

10

15

20

25

Czech Rep.

Source: Annual reports, McKinsey analysis



Exhibit 4 According to strategy executives, technology will shape the future of Eastern European banking; innovation is essential to create value.

Source: Clients surveyed (overall responses: 18)

“What will be the 3 main forces shaping the future of the banking sector in Eastern Europe?”

50

Changes in regulations 67

Technological change, eg, mobile payments

83

33

Top results%

“What will be the 3 most important levers forcreating value in the next 10 years in the region?”

33Growth of intragroup cross-borderoperating models

Reducing costs 50

50

67

Performance of parent banks intheir home markets

Macroeconomic conditions

Product and channel innovation

Strategic focus on specificproducts/services

Accelerated transformation is now imperative We believe that there are three priority initiatives for Eastern European banks to pursue to boost performance in the coming years: portfolio restructuring, improving the regional governance model, and making headway on operating-model innovation, including the development of differentiated approaches to capture the most attractive customer segments. Progress to date with these initiatives has been slow, however, and we believe bolder efforts are needed in the years to come (Exhibit 5).

Portfolio restructuring and improving the regional governance model: Less progressIn last year’s report we argued that the regional-banking landscape was shaped by a history of many subscale and opportunistic acquisitions. As a result, banking groups now need to focus on asset swaps and buyouts to achieve critical scale in each market. Despite the fact that further consolidation is needed, progress is slow as groups are reluctant to write down assets or pursue acquisitions in today’s capital-constrained environment. But failing to address subscale businesses is likely to be costly: our experience suggests that subscale subsidiaries suffer most in downturns due to their weaker margins.

Since our last review, a number of M&A deals have taken place in the region, notably in Russia and Poland. Nonetheless, the lineup of the top ten regional banks by assets has barely changed. Gazprombank is the only new entrant to this group, while VTB gained the most in market share, now ranking second behind Sberbank. Although current low valuations create an unfavorable situation for M&A, there are signs of further exits and consolidation, for example, Bayerische Landesbank’s plan to sell MKB in Hungary. In our view, there is much more portfolio restructuring waiting in the wings.

We also continue to believe that Eastern European banks should revise their regional governance models to more forcefully pursue cross-border skill and scale opportunities. To date we have seen only limited progress to realize this potential. To move forward, Eastern European banks should look outside the region to help them create a clear vision for their operating models. They should look closely at how some banks in Scandinavia have optimized operations across that regional market, which offers parallels to relatively small, adjacent country markets. Emerging-market banks also provide examples: Ecobank, for instance, recently implemented a pan-African approach to standardized operations across 33 countries. We firmly believe that regional governance models should not only pursue the sharing of best practices but should also drive the standardization of formats and processes and drive the collocation of shared services in low-cost centers.

6

Innovation: More important than everBanks must increasingly cope with other challenges, including growing expectations and shifting behavior patterns of consumers as well as intensifying competition, including from nonbank entrants. For example, new payments solutions introduced by telecom companies and online players are threatening payments-related revenues streams. Aggregator and ranking Web sites such as Mint are increasingly becoming the go-to source for customers searching for financial products and have the power to redirect clients. Taken to their extreme, these trends have the potential to change the overall distribution model for financial services and to further dilute the banks’ hold on customers.

The threat of nonbanking attackers is particularly high in Eastern Europe. High margins make the market attractive, while the banks are relatively young compared with their Western European peers and so have less extensive and elaborate infrastructure. Consequently, new technology creates opportunities for “leapfrogging.” In addition, given lower customer value, players must design lower-cost distribution and service models as well as basic product offerings, designed to meet the preferences of local consumers.

With new competitors and technologies increasingly sweeping the market, in addition to the growing sophistication of consumers, erosion of profit margins is in the cards. Banks will need to find breakthroughs to lower their costs. We have seen some efforts in the past several years to reduce branch

infrastructure and personnel—the number of branches in the region (excluding Russia) has started to fall (down 2.7 percent from 2009 to 2011). However, these have not been enough to offset the rising operating costs and, consequently, overall banking-industry operating costs have increased, rising 22 percent in 2011 (Exhibit 6).

To tackle these challenges, the banking executives we surveyed said they believe the greatest focus should be on product and channel innovation (Exhibit 4). Some innovative banking solutions are already emerging in response (Exhibit 7).

— Product and service innovation: Several banks have introduced new payment solutions, such as peer-to-peer services, as well as comprehensive digital payment platforms accessible from smartphones, with wide functionality that ranges from buying movie tickets to settling traffic fines.

— Frontline and distribution innovation: A number of banks are bringing smart solutions to their branch networks, including closing traditional offices in favor of specialized minibranches in hypermarkets and integrating with retail stores. They are also using advanced technologies that reduce the need for face-to-face interaction, such as the use of biometric identification.

— Back-office innovation: A number of banks have started to deploy lean-transformation approaches,

Exhibit 5 There are three key strategic initiatives.

Progress in2011–12

Description

Examples

▪ Concentrating on priority markets, eg, by asset swaps, acquisitions, or market exit from subscale businesses

▪ Building stronger regional governance model to achieveskill and scale economies

▪ Providing innovative services and products to target segments using novel distribution techniques and low-cost back-office solutions

▪ Only a few market players made acquisitions or exited Eastern European countries

▪ No major examples occurred to copy successful models, eg, in Scandinavia or other emerging markets; some discussion started on joint utilities

▪ Some new payment solutions, novel branch formats, and lean-transformation programs have been started

Slow Fast Slow Fast Slow Fast

Portfoliorestructuring

Innovating operatingmodels

Evolving the regionalgovernance model



ESTIMATES

Cost/income ratio%

48%

46%

44%

0%2011201009082007

<100%

2%3%

80–90%

2%

70–80%

6%

60–70%

13%

50–60%

29%

40–50%

31%

<40%

15%

Distribution of cost/income ratio,1 % of banks

100%105%110%115%120%125%130%135%

Absolute costs2007 = 100%

2011201009082007

1 Sample of 95 banks taken from top 10 players in Bulgaria, Croatia, Czech Republic, Hungary, Poland, Russia, Serbia, Slovakia, Slovenia, and Ukraine.

Source: SNL Financial; McKinsey Global Banking Pools

50%

47%

42%

46%

+22%

90–100%

Exhibit 6 Cost-effectiveness varies, highlighting a need for many banks to improve.

Exhibit 7 Some progress has been made, but Eastern Europe is still behind other emerging markets in original innovation.

Lean 2.0transformation

Social-media-embeddedfunctions

Frugalinnovation

Back-office outsourcing,zero-based costing

Fully integratedcross-border

operation

Full service at home

Advanced ATMtechnologies

Specializedbranches

Banking-innovation angles

Next-generationDigitalplatform

Customer-experiencetransformation

Conveniencepayment solutions

Back-officeoptimization

Initiatives in EE1

Initiatives in otheremerging markets

1 Eastern Europe.

Distribution/frontlineinnovation

Product/serviceinnovation

8

including in branch formats and layouts, flexible workstations, organizational structures, and processes, as well as continuous-improvement initiatives. In addition to cutting costs, lean transformation improves service levels and increases customer satisfaction.

— Success stories: In Poland, Alior Sync has pioneered frontline and service innovation with the development of social-media-embedded online-banking solutions, including Facebook links, video-chat functionality, a wide media offering, and other services. Russia’s Sberbank has also made progress in a number of these areas, launching text-message-based peer-to-peer payment services along with “truth verifying” ATMs that grant loans using polygraphs and developing lean solutions that are continuously updated with new ideas drawn from its staff. Meanwhile, Raiffeisen has undertaken a number of successful initiatives in lean transformation, including maximizing workstation flexibility and near-shoring of back-office units to lower-cost rural locations.

While innovative solutions are emerging across the region, Eastern European banks can also learn from new innovative solutions introduced by banks in other emerging markets.

— Product and service innovation:

□ Several Asian banks have introduced futuristic branch layouts with interactive touch screens, opportunities to video chat with experts at other locations, and customized packages specifically targeted at the technology-savvy generation.

□ Frugal innovation approaches also offer great potential. Several financial and nonfinancial firms have been very successful with such approaches in India and Africa (for example, Safaricom’s M-Pesa payment solution).

— Frontline and distribution innovation: African and Latin American banks have developed effective approaches for reaching less populated areas with “traveling bank” solutions, for example, ATMs on buses and boats or other types of traveling minibranches.

— Back-office innovation:

□ Design-to-cost approaches can be applied to rethink operating models and end-to-end processes. Banks that have applied such approaches in mortgage-processing redesign, for example, have achieved savings of 20 to 40 percent.

□ Banks can also think about the next level of outsourcing, using multibank service centers that are able to offer standard IT and operations solutions more cheaply to multiple banks.

In conclusion, the banking sector in Eastern Europe holds much promise for growth but continues to be challenging (Exhibit 8). While a number of markets, such as Poland and Russia, are poised to outperform in the short to medium term, and other countries might also start the rebound, the sector as a whole is facing headwinds due to its reliance on external capital and to growing pressure on margins. While some regional players have started to embark on transformation, it is still too early to judge if these efforts go far enough to make a difference to the fundamentals. In the coming years, we hope to see bolder and more structural change taking hold. Further portfolio restructuring and evolution in regional governance will be needed to achieve scale. Innovation in operating models, formats, and channels is likely to be the key to unlocking the sector’s full potential and to counteracting the risk from new competitors. It is time for banks to shift gears and embrace transformation. Those that do so can expect to capture substantial rewards.



Exhibit 8 Key performance indicators of the Eastern European banking markets indicate growth potential, but also challenges.

Revenuegrowth1 ROE

Loan-to-depositratio

Lending/GDP2

Tier 1 capitalratio NPL3

%, local-currency terms

1 Revenue after risk versus previous year. 2 Total retail and wholesale (including nonbank financial institutions and public) lending volumes to nominal GDP. 3 Nonperforming loans. 4 Not applicable due to negative revenues (–$2.2 billion in 2009, –$0.3 billion in 2010, $3.5 billion in 2011).Source: World Bank; annual reports; McKinsey Global Banking Pools

ESTIMATES

24%

18%

5%

12%

–2%

4%

5%

20%

–16%

18%

19%

18%

24%

18%

11%

25%

8%

21%

18.4%

6.1%

5.6%

17.6%

16.0%

15.2%

16.1%

1.2%

–9.7%

19.2%

10.0%

13.1%

6.6%

–2.2%

–1.1%

14.7%

9.5%

13.5%

117%

129%

117%

90%

85%

82%

148%

149%

137%

104%

117%

122%

120%

137%

141%

113%

95%

101%

73%

80%

75%

56%

61%

60%

71%

80%

76%

43%

58%

62%

44%

56%

55%

42%

45%

49%

10.8%

15.2%

15.6%

10.4%

13.9%

14.2%

8.8%

11.3%

11.0%

10.5%

12.4%

11.7%

8.8%

11.3%

11.0%

15.5%

18.1%

15.1%

2.1%

11.9%

13.5%

2.7%

6.2%

5.6%

2.3%

9.7%

10.4%

5.2%

8.8%

8.4%

2.6%

11.9%

13.4%

2.5%

8.2%

8.0%

19%

–9%

6%

14.2%

8.6%

11.2%

120%

106%

114%

49%

57%

59%

11.2%

11.5%

11.7%

2.5%

5.8%

5.8%

70%

n/a4

n/a4

8.8%

–8.3%

–4.6%

151%

176%

160%

63%

71%

64%

13.9%

20.8%

18.5%

3.0%

15.3%

15.4%

2007

2010

2011

2007

2010

2011

2007

2010

2011

2007

2010

2011

2007

2010

2011

2007

2010

2011

Bulgaria

CzechRep.

Hungary

Poland

Romania

Russia

Ukraine 2007

2010

2011

2007

2010

2011

Slovakia

10

Spotlight on the largest marketsBulgaria: Low base rates have reduced margins

Banking growth and profitability trends — The Bulgarian banking sector has seen another year

of decline in profitability (in terms of ROE); 2011 was the fifth consecutive year for such a decline. The sector operated with a 5.6 percent ROE in 2011, significantly below the Eastern European region’s cost of equity, which is in the 14 to 16 percent range. Despite achieving a relatively strong compound annual growth rate of 9 percent in customer volumes between 2007 and 2011, revenues declined at a compounded annual rate of 2 percent over the same period. The main reasons for the weak performance are lower money-market rates and, as a result, declining deposit margins. Interest and fee margins declined by 109 bps between 2007 and 2011, while risk costs remained at a high level. The sector’s nonperforming loan (NPL) ratio reached 13.5 percent, the highest level since the beginning of the crisis. However, the banking sector became more stable in 2011: there was strong deleveraging, and loan-to-deposit ratios declined by 12 percentage points because retail deposits increased 13 percent while lending saw no growth.

Competitive trends — Foreign interest in the market has increased in

recent years, with players from Eastern Europe and neighboring countries such as Turkey being more active than Western European ones.

— Fragmentation appears to be increasing: the market share of the top five banks has declined from 57 percent in 2007 to 52 percent in 2011.

Challenges and opportunities — As revenues from core lending activities will be

growing more slowly, banks will have to start relying on other, less traditional business segments to build their revenues, for example, encouraging development of a more sophisticated savings culture.

— A package of legislative amendments on bank fees and loan interest rates is under discussion, which could have an impact on bank revenues.

Czech Republic: The benefits of low loan-to-deposit ratios

Banking growth and profitability trends — The Czech banking sector has been one of the most

resilient in Eastern Europe through the crisis. Average ROE has remained at a high level—at 15.2 percent in 2011—and has exhibited a remarkable level of stability compared with other countries in the region. While total deposits increased by 5 percent in 2011, the momentum of lending growth has almost halted, with total lending volumes growing by only 1 percent from 2010 to 2011, reflecting a 3 percent expansion in retail lending but a 1 percent decline in corporate lending. There was no significant change in revenue margins, but thanks to decreasing risk costs, revenues after risk cost increased by 4 percent, a faster pace than GDP growth. The NPL ratio also improved in 2011, falling by 0.6 percentage points to 5.6 percent.

Competitive trends — Three small banks with innovative value propositions

entered the market in 2011, an indication of the attractiveness of the Czech market.

Challenges and opportunities — Some upcoming regulatory changes are likely to affect

the market. The opening of the second pension pillar beginning in 2013 will give banks the opportunity to participate in a market that is estimated could be worth approximately €2 billion by 2015.

— Changes in building society regulations are expected to open the market to all banks rather than only specialized players after 2015.

Hungary: Ongoing regulatory uncertainty

Banking growth and profitability trends — The sector suffered significant losses in 2011, with its

ROE falling to –9.7 percent. Hungary’s weak economic performance compared with other Eastern European countries is just one factor contributing to declining profitability. Regulatory uncertainties persisted in the sector in 2011. Business volumes declined due to



the nationalization of private pension funds, while risk costs rose, mainly due to further deterioration in the asset quality of foreign exchange (FX) loans and mandatory early repayment rules. The NPL ratio of the sector climbed to a record high of 10.4 percent in 2011. In 2012, new lending volumes have declined and NPLs have increased further, driven by the worsening situation in the corporate sector. The combined effect of declining business volumes and after-risk margins led to a significant drop in after-risk revenues. Many banks have tried to reduce their operating costs by restructuring operations, including closing branches—60 branches were closed in 2011 and a further 90 in the first half of 2012.

Competitive trends — While several players are looking to decrease their

exposure to the Hungarian market, major M&A activity is unlikely due to regulatory uncertainties, unless the state itself acts as a buyer.

— To meet their funding needs in 2011, many banks continued to compete for retail deposits by offering rates above the interbank lending rate (typically offering such rates on 3- to 12-month deposits of new savings). Competition for deposits has started to ease during 2012.

— Most players are offering consumer finance only to existing customers and focusing primarily on current account offers.

— Offerings of high-yield mid- and long-term government bonds are creating competition for funds and putting further competitive pressure on bank deposit volumes. These offerings have been supported by a strong marketing campaign; the total volume of these instruments increased 17 percent between the end of 2011 and mid-2012.

Challenges and opportunities — The sector continues to face uncertainties related to

regulations going into 2013. For example, banking-transaction revenues will be hit by the newly introduced “transaction tax.”

— The large-scale program under way to fix the rate of FX-denominated loans will likely halt the growth of retail NPLs and may slowly improve retail-asset portfolios. However, low housing prices will likely postpone any recovery.

Poland: An island of stability, but not without risks

Banking growth and profitability trends — In common with its overall economy, Poland’s banking

sector has remained relatively stable through the crisis. Although ROE has not yet returned to pre-crisis levels, the fall in profitability was less severe than in other countries in the region. Revenue growth in 2011 was driven by decreasing credit risk (risk costs declined by 3 percentage points from 2010 to 2011) and strong volume expansion (11 percent), in particular on the lending side. Cost efficiency increased, reflected in the fall in the sector’s cost-income ratio from 53 percent to 51 percent. Although the Polish banking sector is one of the most stable in the region, its loan-to-deposit ratio (122 percent) is well above 100 percent, and it continues to rely on external funding sources. A possible downturn could hit Poland especially hard due to its banks being far less prepared than their crisis-scarred peers in other countries.

Competitive trends — Poland is one of the most attractive markets in the

region when it comes to M&A activity. There were significant acquisitions during 2011, and more are anticipated.

— Banks are reinventing their distribution strategies. Moves include setting up virtual branches, downsizing branch networks except in large cities, and developing a wide reach in rural and urban Poland using minibranches.

— The rare example of an initial public offering by a small innovative bank—Alior—indicates continued trust on the part of stakeholders.

Challenges and opportunities — Regulatory changes related to interchange fees

(which are currently among the highest in the EU) are expected, as well as changes to bancassurance (most likely resulting in a reduction in bancassurance distribution fees).

— The long-discussed reform of the public-pension system (decreased contributions to the second pillar, with contribution inflows redirected back to the first pillar) is expected to spur greater interest in long-term savings products offered by banks and insurance companies.

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Romania: Continued lending growth even after the bubble

Banking growth and profitability trends — Romania’s banking sector remains vulnerable due

to the rising share of nonperforming loans and the high foreign-currency indebtedness of the private sector. Loan portfolios have continued to deteriorate, although at a slower pace than a year earlier; the proportion of NPLs reached 13.4 percent in 2011. Small and medium-size enterprises (SMEs) were the worst hit: the NPL ratio for SMEs posted the fastest growth and is at the highest level. Credit risk of household loans also rose, with high indebtedness and FX exposure remaining the key challenges. The banking sector’s loan-to-deposit ratio is among the highest in the region (141 percent), a further weakness.

— Volumes posted modest growth during 2011, with lending and deposit markets both increasing by approximately 6 percent. This growth was mainly driven by corporate lending and retail deposits (up 8 percent and 10 percent, respectively). Retail-lending and corporate-deposit market volumes remained flat during 2011, with the level of new inflows staying significantly below pre-crisis levels.

— The banking sector reported an aggregated loss for the second consecutive year.

Competitive trends — A number of banks resized their networks and cut

staff: in 2011, 124 branches were closed, and the number of employees fell by approximately 1,000.

— Foreign-owned banks have started deleveraging; however, a withdrawal of foreign banks from the Romanian market remains unlikely.

— The market has seen even negative margins on new volumes of certain products, as some banks (notably Greek players) paid deposit interest at levels higher than interbank rates to cover their loan-to-deposit gap.

— Top players managed to stay profitable in 2011 due to their scale advantage and large network presence, which remains a key success factor. However, a large portion of the smaller banks suffered losses for the second consecutive year.

Challenges and opportunities — Maintaining a stable liquidity position might become

a challenge as the Tier 1 ratio is among the lowest in the region, although still at 11 percent.

— In the next few years, more aggressive cost cutting is expected, including further branch rationalization.

— Growth of lending and savings is expected to exceed GDP growth in the midterm, as Romania’s lending and savings markets are among the least developed in the region.

— The ability of banks to achieve greater penetration of Romania’s relatively economically underdeveloped rural population—approximately 45 percent of the total—will determine the evolution of the market in the medium to long term.

Russia: Growing state-owned giants

Banking growth and profitability trends — The Russian banking market has delivered one

of the quickest rebounds since 2009. ROE levels returned to pre-crisis levels in 2011, reaching 13.5 percent, well above the Eastern European average of 10 percent. Growth in 2011 was mainly driven by strong volume expansion (26 percent) and declining credit risk. The strong volume growth translated to only moderate banking revenue growth because of eroding corporate-banking margins, mainly the result of intensifying competition. However, performance is very much dependent on the business mix, as retail margins remained strong in spite of the product mix seeing a degree of shift toward savings products with lower margins.

— Russia is one of the most underpenetrated countries in the world by financial-savings measurements, which is expected to result in higher deposit growth rates. The loan-to-deposit ratio is close to 100 percent in the sector on average. However, for many private and international players, the ratio is much higher than 100 percent.

Competitive trends — The overall strong performance of the Russian

banking sector is to an extent a reflection of the performance of Sberbank and its strong customer



base: in 2011 Sberbank accounted for nearly half of the Russian banking sector’s total profits and over a quarter of its assets. A number of other banks saw weaker profitability.

— Competition has intensified: state-owned banks are increasing market share in all segments, and banking consolidation is taking place in the public and private sectors. At the same time, several retail-focused attackers continue to successfully build a visible presence in the market using innovative sales approaches combined with aggressive marketing and pricing.

— Ongoing liquidity pressure keeps funding costs high, while competition and regulation are squeezing banks’ margins.

— Many nonbanking players are entering the space with some initial success, for example, Svyaznoy.

Challenges and opportunities — Large state-owned banks with low funding costs,

healthy capital ratios due to easy access to capital, large regional networks, and the ability to cherry-pick corporate customers enjoy a significant competitive advantage. To be able to stay competitive in their squeezed position, other players in the market should focus on excellence in operations, risk management, and sales and marketing.

— While top banks have a stable capital position (15 percent Tier 1 capital ratio on average in 2011), high lending growth rates along with the upcoming transition to Basel III pose pressure on capital adequacy. These pressures may force some banks to slow down the pace of lending growth or, alternatively, look for additional capital injections or to sell some assets.

— Consumer preferences are shifting toward more complex products, for example, mortgages. Development of the mortgage market is also being supported by state bodies.

Slovakia: Getting a handle on risk and costs

Banking growth and profitability trends — Slovakia’s banking sector has remained strong due

to its embrace of conservative business models, high

Tier 1 ratios, and low levels of corporate and private indebtedness. The banking sector achieved a healthy level of ROE in 2011: 11.2 percent. Business volumes increased by 6 percent, mainly driven by retail-lending expansion, up 11 percent. Although retail risk costs slightly increased, there was a big improvement in corporate credit quality, which led to a better overall risk-cost situation. These positive trends, combined with operational-efficiency improvements, helped the sector to improve profitability significantly from 2010 to 2011. However, due to credit expansion, the sector’s loan-to-deposit ratio has increased by 8 percentage points, and is now well above 100 percent.

Competitive trends — The sector remains quite fragmented for a relatively

small market, with no substantial M&A activity.

Challenges and opportunities — Additional banking taxation poses the biggest threat

to profitability. The new levy will at a minimum reduce ROE by about 1.0 to 1.5 percentage points.

— If overall unemployment worsens and economic growth slows, it could result in lower demand from clients.

Ukraine: Still recovering from the binge

Banking growth and profitability trends — Despite a 13 percent expansion in business volumes

in 2011, the Ukrainian banking sector has still not been able to recover fully from the damage caused by the global financial crisis. Profitability has rebounded from its trough in 2009, but the sector as a whole remained in the red in 2011. Three key factors contributed to this weak performance in 2011. First, the loan-to-deposit ratio remained high at 160 percent (even though that represents a substantial deleveraging from 2010’s 176 percent). Second, the sector’s NPL ratio increased further to 15.4 percent – the highest level in the region. Third, banks’ operating costs increased by close to 30 percent, putting additional pressure on profitability.

Competitive trends — The Ukrainian banking sector remains fragmented,

with the top five banks controlling less than 40 percent of the market and more than 150 banks operating in the country.

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— The market share of foreign-owned banks was 37 percent in 2011, down significantly from its level in 2008 and now at a level that is relatively low for the region. Further exits of West European banks are expected, but there has been a recent push from Russian players to increase market share, especially in the corporate segment.

— Many larger banks have resumed making hryvna-denominated consumer loans, but overall total retail lending declined by a few percentage points in 2011.

Challenges and opportunities — The high level of fragmentation in the banking

sector may present acquisition opportunities, but international banks remain cautious because of the unstable macroeconomic environment and regulatory uncertainty.

— An expected further devaluation of the hryvna against the dollar is putting pressure on Ukrainian banks, since a large part of their stock of loans is still in dollars and so devaluation would lead to increased capital requirements and potentially result in more NPLs.

— While a few players have restructured or sold their NPLs portfolio, a very high level of NPLs persist in the system and this is hampering growth.

— Liquidity is still a major concern for banks. Many banks have offered significantly higher interest rates to try to attract deposits – which has hurt their profitability – while some have slowed their lending significantly while waiting for the situation to resolve.

Krisztina Bákor and Attila Kincses are consultants in McKinsey’s Budapest office, where Miklós Dietz is a principal. Irene Shvakman is a director in the Moscow office.

The authors would like to thank Andrei Caramitru, Jakub Fast, Vladimir Kreidl, Georges Massoud, Tomas Visek, Cornelius Walter, Semyon Yakovlev, and Igor Yasenovets for their contributions to this article, and Valentin Mihov and Tamás Nagy for the underlying analytical work.

Contacts for distribution: Miklós Dietz Phone: 36 (1) 3738520 E-mail: [email protected]

Attila Kincses Phone: 36 (1) 3738741 E-mail: [email protected]

eastern european banking: time to shift gears

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