The global banking business has taken a pounding over the past two quarters, and there’s every indication of more pain to come in the following months. Looking further ahead, however, the industry is expected to resume its impressive expansion. The question is: which banks will be poised to capture the spoils when it does?

The credit crisis has certainly thumped the global financial services industry in recent months. To date, financial services institutions have collectively reported more than US$120 billion in writedowns, largely due to their exposure to the U.S. subprime mortgage market and the various structured products that were created on the backs of those troubled mortgages.

All of this balance-sheet damage has led several firms to seek capital injections. And banks have seen their credit ratings — or, at least, the outlook for their credit ratings — weaken. Fitch Ratings Ltd. reports that negative rating actions on banks jumped to 69 in the fourth quarter of 2007 from just 13 in the third quarter. Banks in developed markets accounted for most of the negative activity, including 19 outright downgrades. The ratio of positive to negative outlooks also plunged to 2:1 in the fourth quarter from more than 4:1 in the third quarter.

The roster of banks facing negative outlooks includes bulge-bracket giants Citigroup Inc., Morgan Stanley Inc. and Merrill Lynch & Co. Inc. In the fourth quarter, CIBC was added to Fitch’s negative watchlist. And the rating agency expects the gloom to deepen this year.

“Higher funding costs are likely to exacerbate the already growing risk aversion on the part of lenders and reduce demand from borrowers,” says a Fitch report, “and a slowdown in economic growth could lead to higher risk costs. This will put pressure on earnings and, in some cases, on capital.”

Already, some firms, including Merrill Lynch and Citigroup, have seen acute pressure on earnings and capital. Merrill Lynch reported a US$7.8-billion loss for the fiscal year ended Dec. 31, 2007, and sought a US$6.6-billion capital injection through the sale of convertible preferred securities to several large investors (including sovereign wealth funds from South Korea and Kuwait). Similarly, Citigroup lost US$9.8 billion in the fourth quarter; it also sold US$12.5 billion of convertible preferreds to its own group of large investors (including SWFs from Singapore and Kuwait).

Closer to home, CIBC had to raise $2.75 billion from a group of institutional investors.

So far, the pain has been most acute for firms with heavy exposures in securities directly affected by the credit crisis, but the accompanying fallout is expected to affect the entire banking industry. At an investor conference hosted by Royal Bank of Canada in mid-January, RBC CEO Gord Nixon suggested that even after banks repair their balance sheets, they are sure to be more cautious with the risks they take in the years ahead.

Taking lower risk generally means accepting lower returns, and this is probably the scenario facing banks for the foreseeable future. This notion is reinforced by a recent report by Ian de Verteuil, an analyst with the capital markets division of Bank of Montreal, which suggests that what he calls “the most powerful trend in banking for the past 25 years” will probably to be curtailed by the credit-market disruption.

The BMO report suggests that the fallout from the credit crunch probably heralds the end of the “disintermediation” fad, which saw banks gravitating away from the simple business of taking deposits, lending them out and capturing the spread and moving toward more complex business models.

Although that trend may have fuelled the banking industry in recent years, it now appears to be unwinding. “Unfortunately, we believe that we are in a world in which banks are being re-intermediated,” the BMO report says. “Other funding sources for the broader economy and for non-deposit-taking financiers are shutting down and banks are being forced to bridge the gap.”

As a result, banks generally will face lower returns on equity and lower capital ratios in the years ahead. And, the report suggests their valuations may decline, too: “With more highly leveraged balance sheets and lower ROE, it is hard to see valuations getting any better, and they could return to the historical lower range.

“The hope is that banks with excess liquidity from central banks will be able to handle re-intermediation smoothly,” the report adds. “But this could easily be a bumpy ride.”

@page_break@Amid all this doom and gloom, investors could be forgiven for fearing that the global financial services industry is slowly imploding. However, there is plenty of reason for optimism. BMO’s report predicts that the Canadian banks will continue to produce solid double-digit ROE and that their earnings volatility will be reduced in the “de-risked” environment.

Moreover, the BMO report suggests, Canadian banks should outperform their global peers “because of our relatively stronger economy, the better balance sheets and the fact that we have disintermediated the banking system less here in Canada.”

This rosy tone was echoed by the CEOs of four of the Big Five banks at the RBC investor conference. (CIBC was absent from the event.) The bank CEOs maintained that their underlying businesses are sound and poised for future growth. They are looking for the silver linings in the clouds created by the credit-market disruption.

Bank of Nova Scotia CEO Rick Waugh noted that one of the positive effects of the new environment is that banks will now be compensated for providing liquidity and taking credit risk, which wasn’t happening in the previous climate.

In addition, although the credit crunch may be able to throw industry trends such as disintermediation into reverse rather quickly, it’s unlikely to have any effect on the fundamental supports for long-term industry growth.

Indeed, new research from McKinsey & Co. predicts that the banking business will continue to outpace underlying global economic growth over the next several years, so that, by 2016, the industry’s revenue and profits will have doubled from present levels and the global market capitalization of banks will have grown substantially, as well. Much of the growth that McKinsey foresees will be powered by demographics and wealth accumulation trends, along with industry-specific drivers such as innovation and globalization.

Already, banking is far and away the world’s most profitable industry, with US$788 billion in global after-tax profits in 2006, up from US$372 billion in 2000, the McKinsey report reveals. The energy industry ranks second, at US$617 billion, far ahead of third-place mining, with earnings of $285 billion. However, McKinsey’s research foresees heady growth in banking’s world-leading profit performance; it expects global banking profits to top US$1.8 trillion by 2016, on revenue of US$5.7 trillion.

Although this represents a slower growth rate than in recent years, it still has the industry outrunning the projected growth in global GDP in the same period. McKinsey also foresees the banking business’s share of global corporate profits inching up, to around 10.5% over the next decade from about 10% today.

However, today’s leading North American and European banks aren’t necessarily poised to become tomorrow’s dominant players, as the sources of industry growth are also expected to evolve. Indeed, McKinsey’s research predicts that growth patterns will be divergent and uneven, as they have in the past, varying within regions, industries and products.

Interestingly, given that banking is such a large, technologically advanced industry, McKinsey finds the industry is one of the few that isn’t being driven by common global pressures. Instead, success is largely dependent on timing and opportunism — being in the right markets at the right time to take advantage of profitable growth trends.

The result is that the banking industry remains relatively fragmented on a global basis. McKinsey reports that the top 20 firms in the global banking business account for only about 40% of the global market cap, compared with an average of 67% in other major sectors. This is expected to change as the years ahead bring increased consolidation.

In the meanwhile, organic industry growth is expected to come from developing regions. McKinsey’s research predicts that about half the new growth will come from emerging markets, a quarter of it will come from North America and a fifth will come from western Europe.

This forecast echoes other studies of wealth-accumulation patterns, including the latest research from Merrill Lynch and Capgemini, which finds that emerging markets, such as Singapore and India, are now the fastest-growing sources of high net-worth investors (those with at least $1 million in assets, excluding their home) in the world. Both countries saw growth in excess of 20% within their wealthy investor populations in 2006.

McKinsey’s study points to Russia and China as powerful sources of future growth in banking. Indeed, the Merrill Lynch/Capgemini research also found that these two nations experienced some of the strongest wealthy investor population growth in 2006. Additionally, India and other Asian nations are expected to fuel the increase in global banking revenue in the years ahead.

Although Asia and various other emerging markets are expected to drive future banking industry growth, financial services firms that aim to capture their share will have to deal with the fact that local markets tend to be different. McKinsey’s research finds considerable divergence in the sorts of products and businesses that are most important to various regions. Canada is one of the most retail-driven banking markets in the world, it reports, whereas firms in high-growth nations, such as China, Russia and Indonesia, derive more than half of their revenue from wholesale banking.

The most important products also vary by market. In the U.S., credit cards and mortgages have been driving revenue growth, whereas corporate lending has fuelled Japan’s banking industry and transactions have powered Germany’s banks. This is, in turn, reflected in the kinds of local factors that have proven most powerful in recent years.

In the U.S., for example, the McKinsey report states that 70% of retail revenue growth from 2000 to 2006 came as a result of increased household borrowing. By contrast, in Germany, 100% of growth was put down to improving foreign exchange rates. India outpaced them both, with revenue powered by simple population growth, coupled with big increases in saving, borrowing and returns.

So, while the overall banking industry is expected to grow handsomely in the years ahead, the identity of the firms that are able to capitalize on these trends may well evolve, too. “In our view, the winners will outshine their competitors by developing better insights into the diversity among markets and the nature of trade-offs between risks and returns,” the McKinsey report predicts. “A superior understanding of the fundamentals that drive value should help these banks exploit short-term cyclicality to their long-term advantage.”

The credit crunch has recently given many of the top banks in the U.S. and Europe — and, to a lesser extent, in Canada — some gruesome wounds. But the industry will surely recover and adjust to the prevailing market conditions. However, long-term growth may be more dependent on their ability to adapt to and compete effectively in much different markets than the ones upon which they have built their fortunes. IE