The banking sector is undergoing a profound shift driven by changes and challenges in the economic, technological, regulatory and competitive landscapes. These dynamics are forcing traditional financial institutions to reevaluate banking roles, change strategies, and embrace technology including artificial intelligence (AI) to maintain market relevance and competitiveness, a new report by McKinsey and Company says.

In a new report, the global consultancy firm looks at the state of the global banking sector, delving into the sector’s evolution over the past year and the trends observed.

In particular, the report highlights the transformative phase within the industry and notes that banking institutions are losing some ground to non-traditional institutions.

This trend is evidenced by the migration of balance sheets and transactions outside of traditional banking systems and into non-traditional institutions.

These institutions, which operate with less capital and often under different regulatory standards, include capital market infrastructure providers. These players are maintaining a sustained growth rate, it notes, and have witnessed robust a 7 to 8% annual growth rate in the past few years despite global crises.

In payments, the shift is manifested by the increase in consumer digital payment processing conducted by payment specialists, which grew by more than 50% between 2015 and 2022.

In capital markets, investment banks and broker-dealers are gaining market share in various products, including equity capital (from 44% in 2015 to 59% in 2022), and foreign exchange (FX) transactions (from less than 1% in 2015 to 22% in 2022).

In wealth and asset management, independent asset managers not owned by a bank or insurer are witnessing improved market penetration as well, recording a rise in their market share from 77% of AUM in 2017 to 81% in 2022.

Changing distribution models

Besides the migration of balance sheets and transactions towards specialized players, McKinsey notes that distribution models are also evolving and moving towards hybrid models.

This shift is prominent in consumer finance, mortgages as well as deposits and loans to small and medium-size enterprises (SMEs) where online comparison platforms are witnessing booming traction. In Sweden and Germany, for example, online comparison platforms are holding more than 40% of the consumer finance and mortgage markets, respectively, the report says.

Concurrently, it notes that embedded finance, a concept referring to the integration of financial products and services into non-banking products and business models, continues to take off.

In 2021, embedded finance reached US$20 billion in revenues in the US, according to McKinsey estimates. The market is expected to double in size within the next three to five years.

In the European Economic Area and the UK, revenue of embedded finance is set to rise to EUR 100 billion by 2030.

Embracing changes and technology

The shift in market share and banking distribution is calling for banks to adjust and adapt.

McKinsey advises traditional banking institutions to improve distribution and focus on selling to customer both directly and indirectly. Embracing a third-party distribution strategy through either partnerships to create embedded finance offerings or platform-based models can create new opportunities to serve customers’ needs with products outside of an institution’s existing business models, it says.

McKinsey also recommends banks to embrace AI and advanced analytics to improve processes, boost productivity and enhance the delivery of products and services. These innovations should be leveraged to deploy process automation, platforms, and ecosystems; cultivate a cloud-based, platform-oriented architecture; and improve capabilities to address technology risks.

McKinsey warns that moving forwards, distinctive technology development and deployment will increasingly become a critical differentiator for banks.

Generative AI, a subfield of AI focused on developing algorithms and models that are capable of generating new text, images, or other media in response to prompts, has been one of the hottest tech trends of the past year.

In the first six months of 2023, equity funding to the space topped US$14.1 billion across 86 deals, data from CB Insights show. The figure represents a fivefold increase compared to full-year 2022 during which generative AI startups secured a mere US$2.5 billion.

Booming interest in generative AI is being driven by promises of significant efficiency gains and cost savings. McKinsey estimates that generative AI could lift productivity by 3% to 5% across the banking sector, delivering value equal to an additional US$200 billion to US$340 billion in annual revenues.

Goldman Sachs, meanwhile, believes that generative AI could drive a 7% increase in global gross domestic product (GDP), translating to almost US$7 trillion. The bank estimates that roughly two-thirds of US occupations are exposed to some degree of automation by AI.

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