* Few banks earn their costs of capital
* Role in global economy is decreasing
* Business models require massive makeovers, consulting firm says
By Jed Horowitz
NEW YORK, Oct 8 (Reuters) - Banks worldwide remain scarred by the 2007-2009 financial crisis and are years away from developing new business models that will produce sustainable profits, according to a new study.
Despite progress in meeting regulators' requirements to build capital, revenue growth is slow, costs are rising and new competitors exploiting digital technologies are emerging, McKinsey & Co said in a report released on Monday evening.
The consulting firm prescribes a rigorous mix of cost cutting, business simplification models adapted from the auto industry and image repair that requires fundamental changes in employee culture and respect for societal values.
"It's the banks' game to lose," Toos Daruvala, a McKinsey director who helped write the report, told Reuters.
The challenges are so great, though, that the consultant expects a host of large and small U.S. banks over the next five years to throw in the towel and merge.
"You will see significant consolidation, particularly among banks with less diversified income streams that are highly dependent on net interest margins," Daruvala said. "They will be troubled 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 has grown faster than countries' gross domestic products "is likely now being broken," the study says. "In both emerging and developed markets, banking revenues are expected to flatline at around 5 percent of GDP for the foreseeable future."
In the United States, where almost two-thirds of U.S. banks are earning less than their cost of capital, investors will have to wait three to five years for returns on equity (ROE) to return to historical averages of 10 to 12 percent, Daruvala said.
Banks cannot control central bank interest rate cuts that are squeezing their net interest margins but have only themselves to blame for outdated business models and internal cultures that fall short of customer needs and perceived societal values, the report says.
"MASSIVE" COST CUTS
Banks that rely heavily on trading and other capital markets activities are particularly challenged because of regulatory changes eradicating their proprietary trading models, according to the report. It prescribes "massive cost cutting" to supplement what has already occurred at the capital markets giants.
Retail banks, however, face decreasing customer loyalty and business banks "no longer enjoy structurally lower funding costs than many of their large corporate clients," the study says.
Compounding banks' problems are technologies that make it much easier for new competitors to steal customers. Wal-Mart Stores Inc and American Express Co on Monday announced a joint venture to provide financial services through a prepaid debit card aimed primarily at low-income customers.
U.S. banks had an average ROE of 7 percent last year, up from 6.2 percent in 2010 as credit quality gradually improved, but "are still far from earning their cost of equity," McKinsey said. Even if interest rates rise and banks reprice their services upward, they are "unlikely to return ROE to acceptable levels" any time soon, the report said.
Expenses for U.S. banks last year exploded to 68 percent of total income from 60 percent in 2010 while revenue grew just one percent, according to the study.
Bank revenue globally rose 3 percent to $3.4 trillion in 2011 from the previous year, slowing from a 9 percent rise from 2009 to 2010. Returns on equity last year fell to an average of 7.6 percent from the low double-digits and profit fell by 2 percent.
INVESTORS CHOKE Investors' doubts remain strong.
More than two-thirds of publicly traded banks in developed markets now trade "significantly" below book value, according to McKinsey, and the average price of insurance against bond defaults for 124 banks sampled by McKinsey rose to the highest level on record last year.
Bank stock prices globally last year traded at 11 times earnings, down from 15 in 2007.
Some analysts challenged the dire report. Focusing on conventional double-digit returns to shareholders when interest rates and funding costs are at historic lows is irrational, said Richard Bove, an analyst at Rochdale Securities.
"Anyone who says that banks should be making traditional returns on equity today when the ten-year Treasury is around 1.6 percent has got to explain themselves," he said.
Bove said he was excluding the outlook for banks that are heavily involved in capital markets such as Goldman Sachs Group
and Morgan Stanley .
Sanford Bernstein analyst Brad Hintz, in a note to clients last week, said few trading units anywhere are generating returns and echoed McKinsey's pessimism about the outlook for their profitability. "Simply cutting compensation ratios and implementing technological improvements may not be enough to reach a target ROE," he wrote.
The good news is that banks that adapt can prosper by financing infrastructure projects that are expected to grow 60 percent by 2020, the report says, and by selling advice and retirement products to aging populations in developed nations and core banking services to new customers in emerging markets.
The study was based on a review of financial data at the world's 30 largest banks, with some data extending to over 2,400 banks in the 69 countries followed by McKinsey.
(Reporting by Jed Horowitz in New York and Steven Slater in London; Editing by Tim Dobbyn)
Keywords: MCKINSEYSTUDY BANKS/