Banks facing double threat of low interest rates and technology deficit

A stunning report from global management consultants McKinsey on the dangers that ultra-low interest rates pose to global banking shows how the next global financial crisis could be much more dangerous than the last.

And while our banking system is not on the frontline of the dangerous battleground, we are headed in that direction. To avoid a potential crisis, banks — including Australian banks - must reinvent themselves

The McKinsey report explains that the ultra-low global interest rate environment is damaging vast areas of the global banking system.

Accordingly, if an extended trade war or some other event caused a sustained downturn, it could be catastrophic for a large number of banks. And because banks are interconnected, the world banking system could be put into jeopardy if banks don’t undergo that reinvention.

Read more | Rates, tax cut boost capital city housing

Banks have been hit hard by record low interest rates, which depress their margins and often cause a withdrawal of deposits. In contrast, rising rates allow banks to lend out money at a profitable rate of interest.

Europe’s negative rates have been savage on its banks. Here in Australia banks are resisting calls from Treasurer Josh Frydenberg to pass on the full interest rate reduction to home barrowers.

The banks say their cost of money is only partly linked to the official Reserve Bank rate.

Australian banks are among the most profitable in the world but if the Reserve Bank keeps lowering interest rates and the banks are forced to pass on the rate reductions then that high profitability will evaporate. We will then be in a similar position to almost 60 per cent of the world’s banks.

The tech threat

But there is a second, chilling warning for Australian banks in the McKinsey report.

All banks face the challenge from financial technology (fintech) developers and companies such as Apple which have entered the banking space.

According to McKinsey, banks only set aside 35 per cent of their IT budgets to innovation and reinvention strategies, whereas fintech players spend more than 70 per cent. To meet the challenge of the disrupters, banks must boost their investment in artificial intelligence-led risk management systems, identifying unique customer bases as well as building out digital talent base and data analytics

McKinsey says: “Whilst imaginative institutions are likely to come out leaders in the next cycle, others risk becoming footnotes to history.

“However, there are steps every bank can take today to change their fortunes and begin the next cycle on a stronger footing, but time is running out”.

Here in Australia, we face a unique version of that challenge. The institutions back a decade or two ago demanded banks boost their profits and that they pay most of those profits out in dividends.

Bank shares skyrocketed. But to achieve those profits the banks hit their customers in ways that were unethical and sometimes illegal. Some of that money must now be repaid and the bill is topping $10 billion.

Had those unsustainable profits been invested in technology rather than paid out in dividends, our banks would have been in a much stronger position.

They now must now increase their investment rate at a time when margins are under pressure. And bank management is being diverted by the fallout from the royal commission, including a new set of rules and regulations. At the same time, there is pressure to lower margins.

The banks have deserved much of the bashing they have received. But in Australia banks are owned by the Australian population via their superannuation. As we hit banks, we are actually hitting ourselves.

Future superannuation returns will be lower.

Losing market share

But, of course, the lower interest rates have boosted house prices which has greatly reduced the threat of bank losses as a result of high-risk lending during the boom.

The most immediate threat to Australian banks is the fact that non-banks are having their lunch and taking market share at a rapid rate. Power has moved to consumers and banks must rapidly adapt via different management practices and new technology.

Globally, McKinsey says the “market leaders,” which include the top 20 per cent of banks, capture almost 100 per cent of the economic value added by the entire industry. There is a second group “resilients” which includes 25 per cent of banks that have maintained leadership in challenging markets. Most big Australian banks would be in the top group. That leaves 55 per cent of world banks that are have big challenges. Many will need to sell.

There is a major banking revolution ahead.