EMEA Banking Practice

Valuation trends
in European banking

Patrick Beitel
Pedro Carvalho
Joao Castello Branco
Ramandeep Chawla
Oliver Vins
EMEA Banking Practice
Valuation trends in European banking 1

Valuation 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
EMEA Banking Practice
Valuation trends in European banking 2
EMEA Banking Practice
Valuation trends in European banking 3

Introduction
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.
1 For a broader discussion of
the outlook for the sector, see
We hope you find this capital market perspective helpful in thinking about value cre- The state of global banking
ation, the implications for the industry, and the strategic and tactical choices that have in search of a sustainable
model. McKinsey & Company,
to be made in the challenging new operating environment. September 2011.
EMEA Banking Practice
Valuation trends in European banking 4
EMEA Banking Practice
Valuation trends in European banking 5

Executive summary
The financial crisis has hit Western Europes 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.
EMEA Banking Practice
Valuation trends in European banking 6

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.
EMEA Banking Practice
Valuation trends in European banking 7

Drivers of total return

to shareholders since
the crisis
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 (R =
0.38) and drop in profitability over the past four years (R = 0.27) explained much of the
TRS decomposition, whereas gross revenue growth (R = 0.08) and change in market 2/3 More details of our
methodology can be found in
expectations (R = 0.07) explained relatively little. the appendix.
EMEA Banking Practice
Valuation trends in European banking 8

Exhibit 1

Exhibit 2
EMEA Banking Practice
Valuation trends in European banking 9

Exhibit 3

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.
EMEA Banking Practice
Valuation trends in European banking 10

Exhibit 4

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.
EMEA Banking Practice
Valuation trends in European banking 11

Exhibit 5

Exhibit 6
EMEA Banking Practice
Valuation trends in European banking 12

Exhibit 7

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).
EMEA Banking Practice
Valuation trends in European banking 13

Exhibit 8

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.
EMEA Banking Practice
Valuation trends in European banking 14

Exhibit 9

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
EMEA Banking Practice
Valuation trends in European banking 15

Exhibit 10

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
EMEA Banking Practice
Valuation trends in European banking 16

Exhibit 11

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.
EMEA Banking Practice
Valuation trends in European banking 17

Exhibit 12

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).
EMEA Banking Practice
Valuation trends in European banking 18

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.
EMEA Banking Practice
Valuation trends in European banking 19

The outlook for European

banks and the implications
for management
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
EMEA Banking Practice
Valuation trends in European banking 20

Exhibit 13

Exhibit 14
EMEA Banking Practice
Valuation trends in European banking 21

Exhibit 15

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.
EMEA Banking Practice
Valuation trends in European banking 22

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.
EMEA Banking Practice
Valuation trends in European banking 23

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 McKinseys European Banking Practice can
apply an exhaustive set of tools, knowledge, and experience to generate an individual
value-creation diagnostic for this purpose.
EMEA Banking Practice
Valuation trends in European banking 24

Appendix

Exhibit A1

Exhibit A2
EMEA Banking Practice
Valuation trends in European banking 25

Exhibit A3

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.
EMEA Banking Practice
Valuation trends in European banking 26

Exhibit A4

Exhibit A5
EMEA Banking Practice
Valuation trends in European banking 27

Exhibit A6

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

4 For more details, see Bas

Initial return on the underlying business. This is the hypothetical TRS if no value is Deelder, Marc H. Goedhart, and
created through growth, increases in margins, or changes in multiples. Cash gen- Ankur Agrawal, A better way
to understand TRS, McKinsey
erated will still create returns to shareholders. Quarterly, July 2008.
EMEA Banking Practice
Valuation trends in European banking 28

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 companys 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.
Valuation trends in Authors:
European banking Patrick Beitel Pedro Carvalho
Principal Principal
Frankfurt Madrid
patrick_beitel@mckinsey.com pedro_carvalho@mckinsey.com
Joao Castello Branco Ramandeep Chawla
Director Consultant
Madrid Delhi
joao_castellobranco@mckinsey.com ramandeep_chawla@mckinsey.com
Oliver Vins
Associate Principal
Frankfurt
oliver_vins@mckinsey.com

Analyses and methodology were supported by McKinseys Corporate

Performance Center (CPC), which leads most of the Firms research on
capital markets and valuation topics.

EMEA Banking Practice

October 2011
Copyright McKinsey & Company, Inc.