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McKinsey casts gloomy eye on world banking

* Few banks earn their costs of capital

* Role in global economy is decreasing

* Business models require massive makeovers, consulting firmsays

By Jed Horowitz

NEW YORK, Oct 8 (Reuters) - Banks worldwide remain scarredby the 2007-2009 financial crisis and are years away fromdeveloping new business models that will produce sustainableprofits, according to a new study.

Despite progress in meeting regulators' requirements tobuild capital, revenue growth is slow, costs are rising and newcompetitors exploiting digital technologies are emerging,McKinsey & Co said in a report released on Monday evening.

The consulting firm prescribes a rigorous mix of costcutting, business simplification models adapted from the autoindustry and image repair that requires fundamental changes inemployee culture and respect for societal values.

"It's the banks' game to lose," Toos Daruvala, a McKinseydirector who helped write the report, told Reuters.

The challenges are so great, though, that the consultantexpects a host of large and small U.S. banks over the next fiveyears to throw in the towel and merge.

"You will see significant consolidation, particularly amongbanks with less diversified income streams that are highlydependent on net interest margins," Daruvala said. "They will betroubled and forced to sell."

The report also sends an ominous message about banks'central role in the global economy.

A 30-year trend in which national average bank revenue hasgrown faster than countries' gross domestic products "is likelynow being broken," the study says. "In both emerging anddeveloped markets, banking revenues are expected to flatline ataround 5 percent of GDP for the foreseeable future."

In the United States, where almost two-thirds of U.S. banksare earning less than their cost of capital, investors will haveto wait three to five years for returns on equity (ROE) toreturn to historical averages of 10 to 12 percent, Daruvalasaid.

Banks cannot control central bank interest rate cuts thatare squeezing their net interest margins but have onlythemselves to blame for outdated business models and internalcultures that fall short of customer needs and perceivedsocietal values, the report says.

"MASSIVE" COST CUTS

Banks that rely heavily on trading and other capital marketsactivities are particularly challenged because of regulatorychanges eradicating their proprietary trading models, accordingto the report. It prescribes "massive cost cutting" tosupplement what has already occurred at the capital marketsgiants.

Retail banks, however, face decreasing customer loyalty andbusiness banks "no longer enjoy structurally lower funding coststhan many of their large corporate clients," the studysays.

Compounding banks' problems are technologies that make itmuch easier for new competitors to steal customers. Wal-MartStores Inc and American Express Co on Mondayannounced a joint venture to provide financial services througha prepaid debit card aimed primarily at low-income customers.

U.S. banks had an average ROE of 7 percent last year, upfrom 6.2 percent in 2010 as credit quality gradually improved,but "are still far from earning their cost of equity," McKinseysaid. Even if interest rates rise and banks reprice theirservices upward, they are "unlikely to return ROE to acceptablelevels" any time soon, the report said.

Expenses for U.S. banks last year exploded to 68 percent oftotal income from 60 percent in 2010 while revenue grew just onepercent, according to the study.

Bank revenue globally rose 3 percent to $3.4 trillion in2011 from the previous year, slowing from a 9 percent rise from2009 to 2010. Returns on equity last year fell to an average of7.6 percent from the low double-digits and profit fell by 2percent.

INVESTORS CHOKE Investors' doubts remain strong.

More than two-thirds of publicly traded banks in developedmarkets now trade "significantly" below book value, according toMcKinsey, and the average price of insurance against bonddefaults for 124 banks sampled by McKinsey rose to the highestlevel on record last year.

Bank stock prices globally last year traded at 11 timesearnings, down from 15 in 2007.

Some analysts challenged the dire report. Focusing onconventional double-digit returns to shareholders when interestrates and funding costs are at historic lows is irrational, saidRichard Bove, an analyst at Rochdale Securities.

"Anyone who says that banks should be making traditionalreturns on equity today when the ten-year Treasury is around 1.6percent has got to explain themselves," he said.

Bove said he was excluding the outlook for banks that areheavily involved in capital markets such as Goldman Sachs Group

and Morgan Stanley .

Sanford Bernstein analyst Brad Hintz, in a note to clientslast week, said few trading units anywhere are generatingreturns and echoed McKinsey's pessimism about the outlook fortheir profitability. "Simply cutting compensation ratios andimplementing technological improvements may not be enough toreach a target ROE," he wrote.

The good news is that banks that adapt can prosper byfinancing infrastructure projects that are expected to grow 60percent by 2020, the report says, and by selling advice andretirement products to aging populations in developed nationsand core banking services to new customers in emerging markets.

The study was based on a review of financial data at theworld's 30 largest banks, with some data extending to over 2,400banks in the 69 countries followed by McKinsey.

(Reporting by Jed Horowitz in New York and Steven Slater inLondon; Editing by Tim Dobbyn)

((jed.horowitz@thomsonreuters.com)(+1 646 223 6826)(ReutersMessaging: jed.horowitz.thomsonreuters@reuters.net))

Keywords: MCKINSEYSTUDY BANKS/