valuation trends in_european_banking

EMEA Banking Practice

Valuation trends in European banking

Patrick BeitelPedro CarvalhoJoao Castello BrancoRamandeep ChawlaOliver Vins

1EMEA Banking PracticeValuation trends in European banking

Introduction ...................................................................................... 3

Executive summary .......................................................................... 5

Drivers of total return to shareholders since the crisis .................................................................................... 7

The outlook for European banks and the implications for management ..........................................................19

Appendix: Value driver trees and methodology ............................................................................ 24



Since 2007 banks have been operating in a turbulent environment of volatile financial markets and changing perceptions of sovereign and private sector risk. Some borrow-ing countries that seemed to be safe havens four years ago now find themselves with virtually no access to the markets. Banks are under pressure both from politicians and the public for their role in the financial crisis and from investors concerned about their weak capital market performance in recent years.

We analyzed major European banks to answer three core questions:

1. How have they performed in stock markets since the onset of the financial crisis?

2. What drives differences in banks’ stock market performance, both in general and within banking segments?

3. What is the outlook for European banking and what are the implications for managers?1

In light of the sovereign debt crisis in the European Union, these questions are more relevant than ever for European banks. Over the summer of 2011, we have seen the negative impact on share prices and, thus, on shareholder value of the latest uncer-tainty. In this situation we believe it is helpful to look at the effects on value creation, and the lessons learned, of the events of the last crisis.

For this report we analyzed financial results and market data from 2007 to 2010 for 37 large European banks with revenues totaling €570 billion in 2010. For the first time, we divided value creation into four segments: retail banking, corporate and investment banking, asset management, and private banking. Our main findings are:

� The negative total return to shareholders (TRS) over the period (2007-2010) was driven purely by a steep drop in banks’ profitability at a group level.

� The segments, however, performed very differently: whereas CIB activities were able to achieve even higher levels of profitability in 2010 than before the crisis, retail banking remains around 70% below its 2007 levels.

� That said, the top quartile of retail banking businesses actually increased their profitability vs. 2007 by protecting margins and by carefully managing their risks – interestingly, superior cost management was not a distinguishing factor between these leaders and the laggards.

� Top performing corporate and investment banking segments outperformed the average only slightly – higher revenue margins were offset by higher operating costs and higher capital demand.

� Retail banking in future may regain its former strength, whereas the sustainability of the high levels of profitability in investment banking seen in 2010 is debatable.

We hope you find this capital market perspective helpful in thinking about value cre-ation, the implications for the industry, and the strategic and tactical choices that have to be made in the challenging new operating environment.

Introduction

1 For a broader discussion of the outlook for the sector, see The state of global banking – in search of a sustainable model. McKinsey & Company, September 2011.


The financial crisis has hit Western Europe’s banks hard. Their total return to share-holders (TRS) fell by 75 percent between early 2007 and early 2009 and has been virtually flat since mid-2009, lagging the recovery of banks in Asian and emerging European markets. A closer look at our sample of 37 major European banks reveals, however, that this general picture conceals huge differences in performance between different players and different segments.

This study set out to answer a series of questions. What are the main drivers of the overall decline in TRS? How does performance differ between banking segments? What do top-performing banks do differently from their peers? What is the outlook for individual segments? The key conclusions of this study cover:

Overall TRS

By breaking it into its main components – return on initial business, value realized through profitability improvement and growth, and change in market expectations – it is possible to show that the 16.1 percent per annum decrease in TRS between 2007 and 2010 was mainly attributable to a drop in overall bank profitability (-32.3% p.a.). This was only partially offset by the more positive market outlook (P/E ratios up from 9.9 to 13.8) which contributed 10.1% p.a. to TRS.

Business unit performance

The profitability (RoE) of the overall banking industry in Europe dropped by 8.5 per-centage points (pp) from 2007 to 2010. However, there were significant variations by segment: whereas CIB contributed positively to the change in group RoE (+1.3pp), for example, retail banking reduced RoE by 9.0pp.

� The retail banking segment is still 70% below the profit levels of 2007, mainly due to a huge drop in non-interest income margins (-1.3pp) and increased loan loss provisions (+1.3pp). The former is a result of declining customer portfolio volumes, a shift to less risky assets, and declining fees from certain products.

� The corporate and investment banking segment proved to be highly cyclical but reached new levels of profitability in 2010 (RoE of 16.6% vs. 11.9% in 2007). The recovery was chiefly due to a disproportionate bounce in net interest income margins (+0.6pp) and good results in fixed-income, M&A, and other investment banking activities.

� The asset management segment recovered from its steep loss in AuM but by 2010 was still 40% below the profitability level of 2007 due to continuing margin pres-sure (-11 Basis points). This is mainly on account of an overall shift to less profitable products and customers.

� The private banking segment was only about half as profitable in 2010 as it was in 2007 thanks to customers shifting to less profitable products and an 18% decline in AuM. Uncertainty among private customers and increasing cost consciousness regarding banking fees were to blame.

Executive summary


What distinguished the banking leaders

Within each of the four segments, the top performers were able to deviate positively from the average by pulling some specific levers:

� In retail banking, despite the poor average performance of the industry as a whole, the top players in 2010 managed to increase their RoE over the 2007 figure (+4.0pp vs. -24pp for the average). Notwithstanding the strong margin pressure in the industry, top banks were able to enhance their margins over RWA by 1.0pp (vs. -1.5pp on average). In addition, they focused on capital light businesses and there-fore needed less equity per RWA (-2.2pp), whereas the overall industry on average increased underlying equity in retail banking (+1.0pp).

� In CIB, top banks were able to outperform the market only slightly (+6pp RoE, against an average of +5pp ). Although top players increased their revenue mar-gins over RWA by 3.0pp against an average of only 1.0pp, that was only achieved thanks to significant investments in customers and platform (+1.4pp compared to +0.1pp in Opex/RWA). In addition, the higher margin business was associated with higher capital requirements.

� In general, top players outperformed the bottom performers in revenue generation and by displaying superior risk management skills that kept loan loss provisions under control in turbulent times. In both retail banking and CIB we see a huge gap in RoE development between the top-quartile and the bottom-quartile play-ers (64pp in retail, 21pp in CIB). Superior cost management was not a source of distinction – in fact, the top-performing CIB segments increased their operating expenditures while low performers decreased their cost base.

The outlook

Over the next few years the retail banking segment is likely to regain its strength, whereas the road ahead may be more challenging for CIB, AM, and private banking.

� The outlook for retail banking is healthy and stable. Risk provisions have declined again in the past year, and it is likely that most risks have now been accounted for. Players that can recoup their margins by fulfilling changing customer needs should lead the revival in this segment.

� In corporate and investment banking, the development of corporate business seems stable. The recovery in investment banking activities, on the back of the boost in fixed-income business, may not be sustainable. Capital requirements will further reduce profitability.

� Asset management and private banking are highly attractive segments in a capital-constrained world due to very low capital requirements and, thus, high RoEs. However, they are influenced by capital market performance, which in turn is closely linked to macroeconomic factors such as the foreign debt crises in the US and Europe. As a consequence, asset management and private banking still need to find answers to margin erosion and shifting customer needs.


The major European banking stocks were hit hard by the financial crisis (Exhibit 1), with the result that total return to shareholders (TRS) dropped by 75 percent in little more than two years. They have been virtually flat since mid-2009, lagging Asian and emerging European banks.

However, this general picture masks considerable differences in the TRS performance of individual banks (Exhibit 2). For instance, although average investor returns between January 2007 and December 2010 were -16 percent per annum, some banks earned a positive return for their investors of 12 percent per year; at the other end of the spec-trum banks earned -62 percent per year.

Capital markets’ expectations of profit growth also differed widely for the banks in the sample. To better understand the growth expectations for market participants, we calculated implied profit growth expectations from the current price to earnings (P/E) multiples and compared them with the actual observed historic profit growth in the period 2007 to 2010.2 Capital markets seem to trust some players to grow but not oth-ers: for instance, the top-bank has an estimated P/E ratio of 15 in 2011 and an implied profit growth of 5 percent per year, while the bottom-bank has an estimated P/E ratio of 5 in 2011 and an implied profit growth of -8 percent per year. Although profits have declined by 14 percent per year for the past four years, the capital markets imply flat profits on average. These findings prompted us to investigate the components of value in more detail.

Decomposing TRS to understand performance differences

To analyze what drives the differences in the performance of the European banks in our sample, we decomposed TRS into its main components: return on initial business, increase in value realized through profitability improvement and growth, and change in market expectations. We did not consider the impact of capital structure.3 As our focus is on analyzing the effect of the initial crisis and subsequent recovery of TRS, we concentrated on the increase in value realized by improving profitability, the increase in value realized through growth, and the change in market expectations.

The average decline in TRS over the period January 2007 to December 2010 among our sample was 16.1 percent per year (Exhibit 3). If we break down this figure, it is evident that most of the decline can be explained by the significant drop in profitability (-32.3 percent per year). Changing market expectations (up by 10.1 percent per year) made a positive contribution to TRS, whereas net revenue growth (down by 2.6 per-cent per year) had relatively little impact.

This finding was confirmed when we ran a regression of the separate components at the level of individual players and found that profitability in terms of RoE in 2010 (R² = 0.38) and drop in profitability over the past four years (R² = 0.27) explained much of the TRS decomposition, whereas gross revenue growth (R² = 0.08) and change in market expectations (R² = 0.07) explained relatively little.

Drivers of total return to shareholders since the crisis

2/3 More details of our methodology can be found in the appendix.


Exhibit 1

Exhibit 2


Understanding value drivers

Since our study focused on explaining how European banks performed throughout the crisis, we looked mainly at the changes that took place between 2007 and 2010. For details of changes from year to year by industry segment, see the value driver trees in the appendix. All margin figures are over risk-weighted assets (RWA) (retail banking, corporate and investment banking) or assets under management (AuM) (private bank-ing and asset management).

Profitability (RoE) on a group level declined dramatically in the first year of the crisis, from 17.6 percent in 2007 to just 1.7 percent in 2008, driven by a huge drop in the operating profit margin from 1.9 percent to 0.2 percent. The capital ratio, by contrast, remained virtually flat at just under 11 percent (Exhibit 4).

In 2009/10 profitability recovered by 7.4pp, driven by a bounce in the operating profit margin of 1.0pp, overcompensating for a 2.5pp increase in the capital ratio to 13.3 percent. By comparison with the precrisis 2007 level, however, profitability was still almost 50 percent down, at 9.1 percent, in 2010.

Overall, throughout the analyzed period (2007 to 2010) on the profit margin side, banks experienced a strong recovery of 0.8pp in net interest income. However, the challenging environment for fee-based businesses such as personal investment prod-ucts, asset management, and private banking took overall non-interest income down by 0.6pp. During this period, there was a substantial 0.8pp increase in provisions and write-offs as a result of lending to subprime categories and the real estate crisis in some countries.

Exhibit 3


On the capital side, capital ratios rose from 10.9 to 13.3 percent as banks sought to meet liquidity needs and future capital requirements, especially those indicated by Basel III. Banks are accumulating equity disproportionately at group level instead of assigning it to segments, in an effort to both satisfy shareholders and meet upcoming capital accords.

We will now take a deep dive into each TRS driver (profitability, growth, and market expectations) and segment to understand the sources of value creation in more detail.

How profitability has evolved in different segments

The performance of the retail banking and private banking segments largely explains the profitability dilution of the past four years (accounting for 9.0 percent and 4.0 per-cent of RoE dilution respectively), whereas corporate and investment banking made a positive contribution to profitability of 1.3 percent (Exhibit 5).

Retail banking

Retail banking has suffered a continuous decline in profitability since 2007, and the 2010 RoE of 8.6 percent was barely more than a quarter of the precrisis level of 32.1 percent (Exhibit 6). This was primarily due to a deterioration in the operating profit margin (from 3.2 percent to 0.9 percent) and a moderate increase in the capital ratio from 10.0 to 11.0 percent in preparation for more stringent capital requirements, especially Basel III.

Exhibit 4


Exhibit 5

Exhibit 6


There are two main reasons for the decline in the operating profit margin. The first is the decline in the non-interest income margin by 1.3pp, which is itself the result of three main drivers:

1. A decline in customer portfolio volumes in the wake of falling prices on capital mar-kets and the accompanying reduction in turnover as customers (especially affluent ones) lost their appetite for investment.

2. The shift by customers to less risky and therefore less profitable products such as deposits because of increased uncertainty and market volatility.

3. A further decline in fees from retail banking products such as current accounts and mortgages.

The second reason for the decline in the operating profit margin is the increase in loan loss provisions (+1.3pp in LLPs/RWA), mainly due to high subprime exposure in coun-tries such as the UK, Spain, and most of Eastern Europe. Interestingly, the 2010 figure is 25 percent lower than the year before, but still 85 percent higher than its precrisis level in 2007 (see Exhibit A2 in the appendix).

However, this is not true for all banks in the sample: the top performers were able to raise their profitability slightly in a negative market environment and achieved a 4pp increase in RoE (average: -24pp; Exhibit 7). The main reasons were their ability to grow revenue margins in the face of a strongly negative market trend (up by 1.0pp as against an average fall of 1.5pp) and their more efficient use of capital (equity/RWA: -2.2pp).

Exhibit 7


The players in the bottom quartile suffered an enormous loss of 60pp of RoE mainly on account of two factors: strong increase in LLPs (LLPs/RWA: +4.3pp) and less efficient use of capital (equity/RWA: +1.9pp). Their considerable exposure to subprime businesses and other depressed credit portfolios harmed these players. Some players acquired banks with poorly performing retail businesses due to high subprime exposure.

Corporate and investment banking

Corporate and investment banking was hit harder than the other segments at the beginning of the crisis. In 2008 its RoE was -15.7 percent, driven by a fall in operating profit margins (-2.4pp; Exhibit 8).

However, the segment enjoyed a strong bounce of 32.3pp in RoE in 2009/10 thanks to a sharp recovery in operating profit margins (+3.1pp) that offset a 1.4pp increase in the capital ratio. That drove the RoE up from 11.9 percent in 2007 to 16.6 percent in 2010. The main reason for the increase in operating profit margin was a strong improvement in both net interest income (up by 0.6pp) and non-interest income (up by 0.4pp).

Repricing was the chief explanation of the rise in net interest income. The classic cor-porate banking activities of banks applied more risk-adjusted pricing and incorporated a liquidity premium. In specialist finance, profitable products such as project finance and leveraged finance took a greater share of the product mix.

Exhibit 8


A strengthened fixed-income business, M&A, and other investment banking activities boosted non-interest income for corporate and investment banks. In 2008, the first year of the crisis, the non-interest income margin fell by 134 percent and turned nega-tive (to -0.9 percent) because of enormous fair value write-offs and trading losses. Since then, these write-offs have been partly “written back on” (see Exhibit A3 in the appendix). In addition, higher volatility and liquidity in the markets have significantly driven up spreads as have bigger volumes of risky proprietary trading over the past two years. Importantly, this strong increase in revenue margins was not wiped out by the risk side, where LLPs/RWA increased only by 0.4pp.

The most profitable performers in corporate and investment banking achieved high growth in RWA-light businesses (Exhibit 9). They increased their revenue margin by 3.0pp by comparison with the segment average of just 1.0pp. However, these profit-able performers had to invest, pushing up their cost margins considerably, by 1.4pp, as against a virtually flat market trend of -0.1pp. Some were able to take advantage of their relatively low exposure to the sub-prime crisis to sharpen their own portfolios and invest in customers and new or upgraded platforms.

The bottom-quartile players suffered a 15pp drop in RoE, largely due to a worse than average performance in revenue margins (-0.9pp vs. +1.0pp).

Asset management

Asset management suffered a dramatic fall in profitability (RoE down by 21.9pp) dur-ing the first year of the crisis, resulting from a fall of 11bp in operating profit margins as well as a rise of 64bp in the equity/AuM ratio (Exhibit 10). Profitability has recovered in

Exhibit 9


the past two years, though mainly thanks to more efficient use of equity (equity/AuM: -52bp). This bounce was not strong enough for profitability to recover fully by 2010 to its 2007 level (being still about 40 percent lower at 17.9 percent).

The fall in operating profit margin was the result of decreasing non-interest income, itself the consequence of:

� A shift in the product mix toward less profitable “defensive” products. That is, from stock market to bond market and cash products as investors lost their appetite for risk. This was especially true for retail investors, who started out with a high share of profitable products in their portfolios. On top of this, there was a trend toward passive products, which again were less profitable.

� A shift in the customer mix from retail to less profitable institutional investors. Retail investments are on average more risky, and therefore their value fell more sharply. At the same time net new money from retail investors dwindled to almost nothing, whereas institutional investors were less affected by the crisis.

� A tendency for customers to become increasingly price conscious.

� The rising share of retail revenues taken by third-party distributors. These players tend to push products such as deposits and neglect asset management products.

Though AuM dropped sharply at the beginning of the crisis, falling by 23 percent in 2008, they recovered subsequently and over the period 2007-2010 were actually up

Exhibit 10


by 3 percent. The value of assets fell until mid-2009 before turning strongly positive.

These factors, namely the fall in fee margin, the increase in equity, and the variability in AuM, demonstrate that asset management is highly dependent on capital market performance.

Private banking

Private banking suffered a steady decline in profitability from 2007 to 2010, with RoE falling from 53.8 percent to 29.7 percent over the period. This was the result of a sharp decline in operating profit margins (47bp to 25bp, Exhibit 11) as a consequence of a drop in non-interest income margin (-14pp) and an increase in costs (+4pp).

The drop in non-interest income margin was mainly caused by two factors:

� A shift in the product mix to less profitable products as customers lost confidence in banks and switched from discretionary- to advisory-based models. They also switched from structured products (alternative investments and stock markets) to less profitable bond market and cash products as their appetite for risk dwindled in the face of increased uncertainty, especially in stock markets.

� Growing price consciousness on the part of customers.

Although the equity/AuM ratio was virtually flat, both numbers changed enormously between 2007 and 2010. AuM fell by 18 percent due to falling share prices as well as declining net new money (especially in 2009/10). Equity declined virtually in line with AuM by 21 percent.

Exhibit 11


Growth

Over the period 2007-2010 net revenues, in other words gross revenue growth minus necessary investments, made a negative contribution (-2.6% p.a.) to the overall TRS performance of the major European banks. Two factors were at work: the combina-tion of medium gross revenue growth of around 2.7% p.a. (CAGR) on group level and the significant investments necessary to strengthen banks’ capital base (around 5 percent, excluding mixed effects). The latter results in an overall negative TRS effect. Leaving the capital issue aside, and looking only at gross revenues, also reveals inter-esting insights.

First, the growth of 2.7 percent per annum over the past four years conceals consider-able differences between segments. Corporate and investment banking was the only segment that made a positive contribution, with 12.7 percent growth per year. All other segments on average shrank, some even dramatically: private banking saw a fall of 11.1 percent a year.

Second, when total revenue growth is decomposed into net interest income and revenues from fees (non-interest income), it becomes clear that the decline in fee income represents a drag on growth. While interest income rose by nearly 16% over the period, fee income dropped by approximately 7.5%. Except for the CIB segment, marked by a 20 percent increase in both interest income and fees, this pattern holds for all analyzed segments. Retail banking was characterized by stable interest income because increased business volume was offset by slimmer margins and decreasing fee income. Despite stable AuM, asset management lost nearly 16% in fee income due to declining margins. The private banking segment was battered by falling AuM and shrinking margins (Exhibit 12).

Exhibit 12


Changes in market expectations

The change in market expectations (as measured by P/E multiples) over the past four years contributed positively to TRS (+10.1%). In this period the P/E multiple increased from 9.9 to 13.8, equivalent to an increase of 12 percent per year. However, the spreads between individual players are considerable. While the P/E ratio of Danske Bank, SEB, and Deutsche Bank show an increase of 30 to 40 percent p.a., the P/E of other banks such as Banco Popolare, SocGen, and KBC lost more than 20 to 40 per-cent p.a. In all cases banks saw their market valuations drop in response to declining income during the period. The different P/E multiples are a sign that the market trusts some banks to recover more than it does others.

The P/E multiple implied a halving of income from 2007 to 2010. But during that period the market cap of banks fell only by one third, reflecting the expectation of the market that banks would recover to some extent in the years ahead.


In the coming years, managers of European banks need to be aware of four key chal-lenges that will affect growth, profitability, and market expectations, and hence TRS. These challenges are regulation, funding and capital, the opening up of growth gaps between different markets, and changes in consumer behavior. How these challenges affect banks will differ by segment.

Retail banking

Shifts in consumer behavior, regulatory moves to satisfy the more stringent require-ments of Basel III and consumer protection, and funding challenges will continue to exert pressure on revenue margins. In particular, increased consumer protection in many European countries will affect retail banking as we know it today. If they are to regain precrisis profit margins, retail banks will need to adapt their proposition to changing needs – for instance, by providing more direct channels – and will have to improve their efficiency. This would still be the case even if risk provisions returned to almost precrisis levels.

Ways to increase efficiency include gradually shifting from branch to direct channels, making a leap forward in internal productivity, for instance, by introducing lean man-agement and standardizing processes, and moving non-core operations to industry utilities (outsourcing).

Retail banks operating in the mostly saturated European markets will only achieve growth by capturing market share. That will entail offering a superior retail bank-ing proposition such as new channels or transparent products so as to rebuild trust among consumers. Alternatively, banks might consider increasing their focus on the growth ‘hot spots’ of Eastern Europe or expanding into emerging markets beyond Europe. Business in countries such as Brazil, Russia, India, China, and South Africa is expected to grow strongly as those countries’ rapid economic development continues and their large unbanked populations start to embrace financial services. Our projec-tions suggest that around 60 percent of revenue growth up to 2020 will be in emerg-ing markets (Exhibit 13). However, some of these emerging growth markets pose challenges in the form of difficult political environments, economic instability, and fierce competition.

Corporate and investment banking

New regulation will have two contradictory effects on this segment. On the one hand, profitability will fall as capital requirements and funding costs increase, making it dif-ficult to maintain high margins on risk-taking business such as lending and proprietary trading activities. Without possible mitigation measures profitability of many business-es will fall below 10% in RoE (Exhibit 14). On top of this, some trading activities, might see higher funding costs of up to 60bp (Exhibit 15). In addition, competition is likely to increase in the plain-vanilla corporate lending business.

On the other hand, investment banking will profit from the trend for companies of all sizes to seek more alternative financing by issuing bonds and equities, which should support the equity and debt capital market businesses. That said, the recent boom

The outlook for European banks and the implications for management


Exhibit 13

Exhibit 14


in fixed-income trading business is likely to slow as markets return to normal. This underlines the continuing cyclicality of the business, which keeps market expectations low – as seen, for instance, in current P/E multiples. As with other segments, emerging markets beyond Europe can be expected to show considerable growth.

Asset management

The crisis revealed that this segment is a riskier business than some people had previ-ously believed. Sizeable AuM fluctuations through net outflows and poor performance meant a shrinking overall revenue pool. In addition, as consumers shifted to less risky and less profitable investments and became increasingly cost conscious, margins came under further pressure and are unlikely to recover to precrisis levels.

New offerings and a lean approach to operations will be key challenges for this seg-ment. However, in a capital-constrained world, asset management is still an attractive business, with a higher RoE (17.9 percent in 2010) than those for retail banking and corporate and investment banking.

As with other segments, emerging markets present highly attractive growth opportu-nities because of their enormous net inflows. Rapid growth should continue in parts of Eastern Europe and the BRIC countries thanks to the demands of growing middle class populations for asset management services. As regulatory barriers fall, for instance, through UCITS IV (Undertakings for Collective Investment in Transferable Securities directives), cross-border business from European asset managers is expected to increase.

Exhibit 15


Private banking

This segment is also highly dependent on the overall evolution of assets under management. Although the effect on performance is uncertain, net new inflows are expected as wealth accumulates. Advisory will continue to be in demand as the invest-ment universe becomes more complex. Because of its low capital requirements and the consequently limited impact of new regulation, this segment remained highly prof-itable through the crisis, achieving an RoE of 29.7 percent in 2010. However, revenue margins are unlikely to attain precrisis levels because of changes in consumer behav-ior, suggesting that banks need to find ways to increase their operating efficiency.

A new wave of private banking and wealth management customers in Asia-Pacific and Latin America will generate growth, with benefits most probably flowing mainly to Switzerland as a long-established offshore booking center. However, the whole European banking market is likely to derive advantages from growth in Eastern Europe and Russia.

Possible ways forward

Top managers in any segment should ensure they understand what drives value at their own institution and what market developments are likely within their segment. This gives them a basis to choose the most value-enhancing strategy for growth and capital allocation, defining the most important KPIs, and enhancing investor commu-nication.

One possible solution to the challenges facing European banks is to adopt one or more of three strategic “vectors” that could lead to attractive and sustainable TRS development. These are:

� Vector 1: Shifting the burden out of banking by reducing the debt financed from their own balance sheets. Banks could move the risk they can no longer afford elsewhere by expanding traditional debt capital markets (DCMs), exploring innova-tive low-cost alternative DCMs, and pursuing securitization via asset-backed secu-rities (ABS) and mortgage-backed securities (MBS).

� Vector 2: Reinventing the cost base to recapture profits. Banks can shift from branch to direct channels, improve their internal productivity, move non-core oper-ations to industry utilities, and engage in transformational M&A.

� Vector 3: Capturing new opportunities by raising fees and passing more costs to customers. Banks can tap into new pockets of demand and revenue via smarter pricing, innovative customer-centerd approaches, and selective risk taking backed by better risk management.


One further important challenge will be to set investor expectations at appropriate lev-els. This will be essential if valuation multiples such as price-to-earnings and market-to-book ratios are to move back up towards their precrisis levels.

Banks that take these measures can pave the way for positive TRS developments in the future and regain their attractiveness for investors.

* * *

A detailed analysis of the performance of their bank and comparison to industry benchmarks in terms of valuation, value creation, and operational drivers can improve managers’ understanding of the actions that will create value for their business and how to communicate them successfully to the market. The Corporate Finance & Strategy Center of Competence within McKinsey’s European Banking Practice can apply an exhaustive set of tools, knowledge, and experience to generate an individual value-creation diagnostic for this purpose.


Appendix

Exhibit A1

Exhibit A2


Value driver trees

In the following we present the complete value driver trees over the analyzed period for the industry on a group level as well as for the four segments. To account for the importance of scarcity of capital today, we normed profits, revenues (and their breakdown), costs, and additions to LLPs of the following profitability breakdowns at group level, as well as for retail banking and corporate and investment banking by risk-weighted assets (or margins). For asset management and private banking we normed respective numbers by assets under management.

Methodology

Sample selection. We selected European banks by the size of their 2010 revenues. So that we could connect value creation to TRS, only publicly listed companies were included in the sample. It comprises 37 banks.

Data sources. We used two main sources: annual reports and Datastream. We used the segment reporting in the annual reports of the banks in the sample for the years 2007 to 2010, and eliminated currency effects by looking at data in local currency and convert-ing the historic time series to euros at one exchange rate. The capital market data for January 31, 2007 to December 31, 2010 was predominantly sourced from Datastream and supplemented with some data from Bloomberg for our TRS decomposition analysis. We again used local currency wherever available to rule out currency effects, but this was not possible for TRS decomposition, where euro terms have been applied.

Exhibit A3


Exhibit A4

Exhibit A5


Segment allocation. We applied a bottom-up approach to defining the four segments – retail banking, corporate and investment banking, asset management, and private banking – to keep the segments clean and ensure that the segment analysis was not distorted by extraneous activities (Exhibit A6). A reported segment was assigned only if it clearly fitted into that respective category. The analysis did not cover the corporate center, nonbanking businesses, and M&A specialities.

Implied growth expectation. The base for the analysis is the simplified valuation formula:

Price = earnings ÷ (cost of capital – growth rate)

Our assumption for cost of capital – 11.5 percent for all banks – is based on the his-toric market average.

Decomposition of TRS. Total returns to shareholders can be decomposed into the fol-lowing five components:4

� Initial return on the underlying business. This is the hypothetical TRS if no value is created through growth, increases in margins, or changes in multiples. Cash gen-erated will still create returns to shareholders.

Exhibit A6

4 For more details, see Bas Deelder, Marc H. Goedhart, and Ankur Agrawal, “A better way to understand TRS,” McKinsey Quarterly, July 2008.


� Profitability improvement. This is the improvement in RoE from increasing oper-ating margins or capital efficiency. It will also result in value creation and hence returns to shareholders.

� Net revenue growth (gross revenue growth minus investments required for growth). If a company’s total income grows, it will result in value creation as long as the growth is profitable: that is, provided the impact of gross top-line growth is larger than the investments made (including goodwill paid) to fund this growth, whether organic or inorganic.

� Change in market expectations. The value of the company can also increase if there is an increase in the P/E multiple driven by changes in investors’ expectations.

� Others. Issuing or acquiring shares does not in itself change the value of a com-pany or create shareholder returns. However, issuing shares or acquiring shares at a premium or at a discount to the market price will create or destroy value.

The RoE dilution analysis is a ceteris paribus (“all other things being equal”) analy-sis: it describes how the RoE in, for example, the retail banking segment would have changed if earning/profits and equity changed but all other factors remained constant.

Definitions. All averages in the profitability breakdowns, top performer analyses, and value driver trees are weighted averages, as we wanted to analyze the evolution of the market as a whole and avoid skewing data toward smaller banks in the sample. Return on equity is calculated as operating profit after risk but before tax, divided by book equity. Margins for the sample as a whole, for retail banking, and for corporate and investment banking were calculated as percentages divided by risk-weighted assets. For asset management and private banking, margins were defined as basis points divided by assets under management.

EMEA Banking PracticeOctober 2011Copyright © McKinsey & Company, Inc.


Authors:

Patrick Beitel Principal Frankfurt [email protected]

Joao Castello Branco Director Madrid [email protected]

Oliver Vins Associate Principal Frankfurt [email protected]

Pedro Carvalho Principal Madrid [email protected]

Ramandeep Chawla Consultant Delhi [email protected]

Analyses and methodology were supported by McKinsey’s Corporate Performance Center (CPC), which leads most of the Firm’s research on capital markets and valuation topics.

valuation trends in_european_banking

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