Banks' strategic choices will be tested as they contend with multiple fundamental challenges to their business models. They must demonstrate conviction and agility to thrive.

Key messages

• A slowing global economy, coupled with a divergent economic landscape, will challenge the banking industry in 2024. Banks’ ability to generate income and manage costs will be tested in new ways.
• Multiple disruptive forces are reshaping the foundational architecture of the banking and capital markets industry. Higher interest rates, reduced money supply, more assertive regulations, climate change, and geopolitical tensions are key drivers behind this transformation.
• The exponential pace of new technologies, and the confluence of multiple trends, are influencing how banks operate and serve customer needs. The impact of generative AI, industry convergence, embedded finance, open data, digitization of money, decarbonization, digital identity, and fraud will grow in 2024.
• Banks, in general, are on sound footing, but revenue models will be tested. Organic growth will be modest, forcing institutions to pursue new sources of value in a capital-scarce environment.
• Investment banking and sales and trading businesses will need to adapt to new competitive dynamics. Forces like the growth of private capital will challenge this sector to offer more value to both corporate and buy-side clients.
• Early 2023 shocks to global banking have galvanized the industry to reassess their strategies. While bank leaders focus on proposed regulatory changes to capital, liquidity, and risk management for US banks, there is much to be done to evolve business models.

Navigating the changing contours of the global economy

A slowing global economy coupled with a divergent economic landscape will challenge the banking industry in new ways in 2024. Although recent efforts to combat inflation are showing signs of success in many countries, the risks brought to light by supply chain disruptions, rewiring of trade relationships, and ongoing geopolitical tensions will complicate economic growth worldwide. Extreme weather-related events, such as floods, heatwaves, and hurricanes, may also cause severe economic disruption.

With this backdrop, the International Monetary Fund (IMF) expects the world economy to grow at no more than 3.0% in 2024.¹ Advanced economies—i.e., the United States, the Euro area, Japan, the United Kingdom, and Canada—are forecast to experience tepid growth at 1.4% in 2024.² But many emerging economies should see higher growth on the back of strong consumer demand, younger demographics, and improving trade balances. In particular, India is expected to have one of the strongest growth rates: 6.3% in 2024.³

On the other hand, China is facing a potential economic slowdown with weak consumer demand and distressed property markets. The weakness in Chinese exports and imports will not only impact its trading partners, but may well challenge supply chain dynamics and further weaken global recovery. Recent efforts to revive consumer and corporate confidence in China could influence economic growth in other countries, particularly in Asia.

Global inflation is expected to drop to 5.2% in 2024, from a high of 8.7% in 2022, as per the IMF. In countries such as the United States, the labor market and consumer spending are showing signs of deceleration but are still elevated, challenging the targets set by central banks. In fact, the IMF predicts that inflation in almost all countries will remain above target rates.⁴

Central banks will be fine-tuning their monetary policies through 2024 (figure 1). The federal funds rate in the United States is expected to remain elevated at or above 550 basis points going into 2024 but may drop to between 450 and 500 basis points in the second half of 2024, according to latest FOMC projections.⁵ The European Central Bank (ECB) is expected to begin decreasing interest rates; in August 2023, the ECB policy rate stood at 3.75%, matching the peak in 2001.⁶

Meanwhile, the Bank of England is expected to lower the policy rate in the first half of 2024 after reaching a peak of 5.75% at the end of 2023.⁷ The story is similar to the Bank of Canada: Rates should decline in the second half of 2024 after surpassing 5%, as per the Canadian Economic Quarterly Forecast by TD Economics.⁸ In contrast to other central banks, the Bank of Japan has kept the policy rate near zero, but its July 2023 meeting indicated that it would tweak the bond yield curve control schemes to respond more nimbly to price pressures.⁹

But generally, central banks’ quantitative tightening measures will contract global money supply. In fact, in the United States, money supply, as measured by M2, has been falling at its fastest rate since the 1930s.¹⁰

These challenges will result in divergent and sporadic economic growth. Some economies will face a brighter future, while others will still be fighting stickier inflation and low growth.

How will the macroeconomic environment in 2024 impact the banking industry?

Banks globally will face a unique mix of challenges in 2024. Each of these hurdles will impact banks’ ability to generate income and manage costs (both interest costs and operational expenses).

Deposit costs are here to stay—for now

Higher interest rates have been a boon to the banking industry. In 2022, net interest income increased significantly in many jurisdictions, with American and Canadian banks posting a rise of 18% year over year (YoY), followed by their European peers at 11%.¹¹

However, elevated rates will continue to push funding costs higher and squeeze margins. The pace and steepness of the current rate cycles have dramatically boosted the cost of interest-bearing deposits for US banks. But these costs have risen more sharply for regional and midsize banks. For instance, deposit costs for the largest banks stood at 2.2% in Q2 2023, compared to 2.5% for the smaller banks.¹² This is a similar pattern in other countries that have experienced rate hikes.

Going forward, the global banking industry may be hard-pressed to bring down high deposit costs (and lower deposit betas) even as interest rates drop. Customer expectations of higher rates, coupled with increased market competition, will force many banks to offer higher deposit rates to retain customers and shore up liquidity. The situation will vary by region, though. European banks may be able to decrease deposit costs more rapidly, for instance. The European banking industry has not faced as much competition from money market funds, unlike in the United States. During the banking turmoil in March 2023, inflows into Europe’s money market funds totaled US$19.3 billion, dwarfing in comparison to US$367 billion into the US money market funds.^13,14 Similarly, Asian banks, in India, for instance, may sustain higher rates in the wake of stronger economic growth. In fact, banks in the Asia-Pacific (APAC) region are expected to outpace global peers in generating stronger net interest income.

Loans growth will be modest, at best

In terms of loan growth, we expect demand to be modest given the macroeconomic conditions and high borrowing costs. Banks will also likely continue their restrictive credit lending policies. According to the recent bank lending surveys conducted by the Federal Reserve and the ECB, many banks have already tightened credit standards across all product categories. They anticipate further tightening due to a less favorable economic outlook and likely deterioration in collateral values and credit quality.^15,16

However, the impact of the macroeconomic environment will be disparate across loan categories. Consumer spending has remained robust in major economies, but as consumer savings deplete, demand for credit card and auto loans should remain strong. At the same time, across the United States and Europe, bank loan demand from firms has decreased significantly. Bank loans to corporates may weaken in the short term but could pick up later in 2024. (See sidebar, “Real estate jitters” for commentary on commercial real estate loans.)

Climate change should also play an important role in loan demand and credit availability. According to a recent EU Bank survey,¹⁹ over the next 12 months, banks expect a stronger credit tightening due to climate risks on credit standards for loans to “brown” firms, while a net easing impact is expected for green firms and firms transitioning to decarbonization. Firm-specific climate-related transition risks and physical risks should have a much larger role in credit disbursements going forward.²⁰

The combination of higher deposit costs, lower policy rates, and somewhat constrained loan potential can adversely impact banks’ ability to generate strong net interest margin (NIM) in 2024. In fact, banks’ NIMs may already have peaked, as suggested by recent bank earnings. US and European banks should experience a decline in net interest margins in 2024 (figure 2). APAC banks are more likely to enjoy stronger net interest income next year with a higher—and possibly rising—rate environment in many developing countries. These new factors will likely force banks to reassess the true cost of deposits and how they may be deployed.

More noninterest income sources will be sought out

Banks should prioritize noninterest income in 2024 to make up for the shortfall in net interest income. Noninterest income is expected to grow meaningfully in the next few years (figure 3). Most banks will seek to raise fee income through a variety of channels, but they may face some constraints in doing so. Consumer-focused fees, such as overdraft fees, nonsufficient funds fees, and credit card late fees, could attract regulatory scrutiny.

However, banks with stronger advisory, underwriting, and corporate banking franchises should have more room to grow their fee income. Clearer valuations and a backlog of deals should lead to higher M&A and issuance activities in the United States, boosting fees. However, reduced volatility across different products will crimp revenue growth in both equities and FICC (fixed income, commodities, and currencies) trading.

Sharpening the cost discipline

With the rising pressure on revenue generation, cost discipline will become even more of a priority, and possibly a competitive differentiator for banks. Efficiency ratio has been improving in the last few years globally (Figure 4), but it is expected to inch higher in 2024, due to sluggish revenue growth and high operating and compensation expenses. Many banks will also continue to invest in technology to remain competitive. Attracting talent in specialized areas such as artificial intelligence, cloud, data science, and cybersecurity should bump up compensation expenses, even as banks rationalize in other areas. In addition, tight labor markets and accelerated wage growth in traditional offshore locations should add to the industry’s cost pressures.

Guarding against loan losses

In the first half of 2023, many banks raised their provisions for future credit losses, anticipating elevated loan defaults from a pandemic-era low. For instance, in Q2 2023, cumulative provisions for the top 10 US banks rose by 26% quarter over quarter (QoQ).²¹ Credit quality is expected to deteriorate as customers' ability to pay off loan diminishes, and the full impact of inflation and monetary tightening is felt by businesses and consumers. There is already evidence of rising delinquencies in certain loan categories, such as credit cards and CRE.^22,23 Similarly, corporate default rates in the speculative grade may also increase.

While credit quality is decreasing and showing stress in specific segments, credit quality as a whole appears to be normalizing to prepandemic levels. Banks are continuing to build reserves to restore reduced balances over the last few years. Most large banks, globally, seem to have adequate liquidity and strong capital buffers to withstand a severe downturn, as evidenced by recent stress test results by the Federal Reserve, the ECB, and the Bank of England.^24,25