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The state of retail banking: Profitability and growth in the era of digital and AI

The last few years have been among the most successful in the recent history of retail banking, with a confluence of macroeconomic trends driving growth and profitability. In some geographies, pandemic-era government stimulus lifted economic growth, fueled consumer spending, created favorable conditions for balance sheet expansion, and helped keep credit risk in check. Following the pandemic years, rising interest rates improved banks’ net interest margins as loan interest grew faster than the cost of deposits.

About the authors

This article is a collaborative effort by Amit Garg , Marti Riba, Marukel Nunez Maxwell , Max Flötotto , and Oskar Skau, with Matic Hudournik, representing views from McKinsey’s Banking Practice.

Globally, according to McKinsey Panorama, banking 1 Includes corporate banking, investment banking, and retail banking. ROEs have reached their highest point since the onset of the global financial crisis, roughly 12 percent in 2023, significantly outperforming recent historical averages, including the roughly 9 percent average the industry experienced in 2013–20. In 2023, the global retail banking market also surpassed the $3 trillion revenue mark on the back of sustained growth of about 8 percent annually in recent years (Exhibit 1).

A turning point

The outlook, however, for global retail banking is more muted than its recent performance would suggest. External forces are combining to pressure the sector in the key economic metrics of asset growth, margins, and operational and risk costs.

In 2022, following a long period of deposit growth driven particularly by favorable fiscal and monetary policies through 2021, deposits started to decline (North America), or their growth decelerated (most other regions) 2 McKinsey Panorama. as governments around the globe tightened monetary policy and moderated fiscal policies. Looking forward, banks are expecting the higher-interest-rate environment to continue despite some recent and—potentially—upcoming reductions in interest rates by central banks. In a recent survey by the McKinsey Global Institute, two-thirds of senior banking executives shared that they expect some form of high-interest-rate scenario. This implies a longer-term environment of positive real interest rates, in which nominal interest rates are higher than expected inflation, and a period of quantitative tightening with a more limited money supply. Given these trends, we anticipate that deposit growth will remain sluggish for retail banks.

The second major headwind banks will face will be margin pressure. Over the last two years, as interest rates increased, retail banks have seen their margins peak. However, intensifying pressure on fees and interest revenue from regulatory headwinds and the expected ongoing lowering of interest rates, respectively, will compress bank margins. Deposit betas are catching up with lending betas, and some central banks have already started to reduce rates. For example, the European Central Bank cut interest rates in June 2024 for the first time since 2019, then made another cut in September. The US Federal Reserve followed on September 18 with its first cut since March 2020. These actions will lead to steady margin contraction for retail banks as lending rates begin to drop faster than cost of funds.

Interest margins are likely to account for the bulk of margin contraction facing retail banks—roughly 70 percent through 2026, with some variance across regions. If regulators continue to closely monitor and intervene in bank activities and offerings, particularly fees for mass-market products and services like credit cards, overdrafts, and deposits, margins will face additional downward pressure.

The impact of these headwinds on retail banking margins will, of course, vary by region, but the trend is globally consistent. We anticipate margin declines of between 5 and 10 percent by 2026 across various geographies.

Finally, operating costs for retails banks are increasing (Exhibit 2), driven by four trends: wage growth, increased occurrence and magnitude of financial crimes, rising imperatives for technology investments, and growing credit risk. This confluence of trends will force banks to reenvision how they manage cost productivity in the coming years.

To counter these challenges, banks will focus on two fundamental imperatives: doubling down on primary relationships and protecting margins. In our view, banks will pursue these goals with a combination of traditional levers—for example, improving branch effectiveness—and next-generation capabilities such as digitization, AI, and generative AI (gen AI).

The battle for primacy

In recent years, through 2021, given near-zero interest rates across many geographies, banks benefited from the freedom to grow their balance sheet in an almost unconstrained way. This approach now needs to be recalibrated. Banks must focus on nurturing primary customer relationships through deeper, more meaningful engagement in order to lower their cost of funds and improve their liquidity profile.

Banks can develop primacy and deepen customer relationships with three measures: a mobile-first integrated distribution strategy, innovation in products with relationship-based incentives and integrated rewards, and hyper-personalization to foster ongoing engagement.

Mobile-first integrated distribution strategy

Globally, the share of consumers actively using mobile for their banking needs climbed 18 percentage points between 2020 and 2023, to 57 percent, according to Finalta by McKinsey . Similarly, mobile service touchpoints have proliferated over the same time period. The number of annual touchpoints grew by 72 percent, reaching 150 annual touchpoints per customer and surpassing some leading e-commerce players.

Based on this trend, banks should position the mobile channel as the primary orchestrator of consumers’ interactions (Exhibit 3). Mobile thus becomes the point from which customers are steered—if needed—to the channel that best suits their needs and expectations. Banks need to invest in a seamless mobile user experience that adds structure and clarity to their journey, rather than overwhelming the customer. There is clear evidence from Finalta that leaders in mobile are now leading in retail banking overall: they outgrow the competition, have lower cost to serve, and deliver superior customer experience.

Most banks globally have been cutting down their physical footprint, but many are doing so without a clear strategy for balancing the cost savings and the revenue impact. According to proprietary research from Finalta, branches in North America accounted for 72 percent of newly acquired current accounts in 2023, representing 92 percent of new current account balances; in Asia–Pacific, the figures are 55 percent and 80 percent, respectively (Exhibit 4). The branch story is more complex in Europe, where nearly half (44 percent) of balances are acquired digitally, but this still leaves the majority of new current account balances coming through branches.

Innovation in relationship-based incentives and rewards

Relationship- and rewards-based strategies are an effective tactic that banks often use to deepen relationships and guard against competition from digital attackers. Leading banks are increasingly providing three types of benefits to reward consumers with bundled product offerings:

Fee or price waivers. Waivers are the most common way to incentivize customers to use more products and services. This type of benefit gives customers discounts or free products and services based on the number of product relationships they have with the bank.
Accelerated rewards. Here, customers who have deeper and broader relationships with the bank are given access to accelerated proprietary rewards programs. Such rewards can be from within a bank’s internal ecosystem or part of an external program, such as airline points.
Nonbanking benefits. Some banks are going a step further by offering lifestyle benefits unrelated to banking. These benefits include access to hard-to-obtain tickets or cultural experiences, “free” entertainment passes, and exclusive invitations.

Double down on hyper-personalization

According to our research, roughly three out of four consumers report feeling frustrated when the website content of the brands they frequently interact with is not personalized. Fortunately for banks, the tools and services available to meet these expectations and deepen relationships through highly personalized customer engagement are keeping pace with demand. There has been an explosion of both data and providers that specialize in helping companies deploy a more personalized engagement strategy, more granular audience targeting, and dynamic optimization of marketing content and creatives.

Banks own more customer data than companies in most other industries, but they are behind many other consumer-facing sectors when it comes to personalization at scale. Banks seeking to unlock the full potential of personalization can focus on five key priorities: identify and prioritize use cases based on value; rapidly activate and optimize at scale; deploy martech and data enablement; develop an agile operating model for personalization; and build talent and capabilities.

Protecting against margin compression with digital, AI, and gen AI capabilities

As retail banks face headwinds from a host of cost pressures, it becomes more important to look closely at where they can better manage their margins. We see three key areas of focus that will set leading banks ahead of the pack: next-generation analytic capabilities to protect revenue margins on the deposits and assets sides, a holistic approach to fraud that balances prevention with a bank’s growth strategy, and proactive adoption of gen AI tools to boost productivity.

Next-generation analytic capabilities for deposits and lending

Given the uncertain interest rate environment and volatile deposit landscape, retail banks will need to take a closer look at their pricing strategies and elevate their analytical sophistication and agility when it comes to pricing on both the asset and liability sides.

Deposits will continue to be a crucial battleground for retail banks. They will need a system for pricing with precision and building deeper visibility into their customer base. The following tools can help banks achieve best-in-class deposit pricing and retention management:

Dynamic and personalized pricing strategy. Banks should develop a relationship-based strategy that targets newly acquired and long-standing customers separately (for example, based on price sensitivity) and empowers the front line to take a personalized approach based on specific customer attributes.
Customer balance sheet visibility. Banks should identify the data required to enable a near-real-time 360-degree customer view, including transaction flows, demographics, and key churn events. This will help banks understand and act on critical moments for deepening relationships.
Advanced deposit modeling. Leading banks will build analytics capabilities that support a fact-based execution of their overall deposit strategy. For example, bespoke deposit models can test price elasticity at the relationship level or balance the trade-off between getting better rates and growing deposit volume.
Unified operating model. To win the battle for deposits, banks must ensure they are coordinated across the organization and have a governance model that allows for dynamic deposit management.
Rapid decision support. Leading banks will put in place the capacity to track the effectiveness of promotion and marketing campaigns on a daily and weekly basis. With this capability, leaders can make fact-based decisions and set strategy accordingly.

Improving pricing on the liability side is only half the battle. Many retail banks still lack a modern pricing strategy when it comes to consumer lending products. Instead, they revert to tactical pricing adjustments based on the competition, as opposed to truly understanding price sensitivity and the long-term value of their customers. Analytics leaders will take advantage of the higher (and potentially more volatile) interest rate environment to improve their lending margins based on a deeper understanding of their product economics, refining their view of the customer and their risk profile. Most capabilities described in the deposit section apply to lending as well.

Holistic approach to fraud

Most banks still see fraud management as a pure trade-off on the curve between revenue or customer experience and losses, tightening or loosening controls as they see fit. Given the growth in fraud, banks will need to shift that curve and minimize the trade-offs. To do so, they need a comprehensive, end-to-end approach across prevention, detection, and resolution—and, importantly, a system that guards against losses while setting an appropriate risk appetite and supporting healthy revenue growth.

A series of actionable levers can enable retail banks to take a more resilient and proactive approach:

Look beyond fraud losses. Fighting fraud in the current environment requires that most banking executives make a significant shift in mindset. Enhancing mitigation is no longer synonymous with tightening controls. Banks that tailor their fraud prevention systems to limit false positives can enjoy a significant revenue impact.
Set an acceptable risk appetite. Very few banking executives have set a level of fraud losses that they deem acceptable as they seek to balance revenue growth and business strategy with prevention. Only by setting appropriate thresholds can banks measure fraud accurately and consistently, which enables active target setting and monitoring.
Take an end-to-end approach aligned with product strategy. Banks can fight fraud using a mix of prevention, detection, and resolution strategies. But very few are calibrating fraud enhancement strategies with their broader business objectives. For example, a recently launched fintech with a valuation driven by its number of users might consider a more lenient approach to letting new entrants into their ecosystem but be more stringent in fighting fraud at the transaction level.
Streamline fraud operations. Finally, banks can improve their fraud approach by calibrating resources with their overall portfolio risk profile. For example, if a bank has decided to loosen controls as part of a customer acquisition campaign, they could simultaneously scale up their fraud operations team to prepare for a spike in case volume.

Proactive adoption of gen AI

Gen AI is rapidly reshaping productivity in the financial services landscape. For retail banks, most use cases with sufficient maturity center on developer productivity and operations, but future applications will span a much broader spectrum and likely include areas such as product design. Today, four domains are emerging as initial gen AI focus points for banks:

Contact centers. Leading banks are testing gen AI’s capacity to deliver value in contact centers and through the use of virtual assistants—AI “copilots”—to offer real-time suggestions for script generation based on rapid customer profiles.
Operations and technology. On the operations and technology front, gen AI can reduce costs for a wide range of back-end processes, using automation to replace “manual” labor (thereby freeing up time for employees to focus on more value-added tasks) and accelerate time to completion.
Legal, risk, and fraud. Gen AI will have a significant productivity impact on activities requiring document interpretation and text generation. Given the nature of these activities and processes, the use cases for legal and risk functions are wide-ranging.
Talent management. Finally, retail banks can utilize gen AI to create efficiencies for their talent functions and improve the productivity of their existing workforces.

As market conditions become more challenging and the competitive environment shifts, the moment is fast approaching when banks will need to revamp their strategies and execute with precision. Leading institutions will set a course rooted in the basics of deeper customer relationships and superior operating efficiency, enabled by strong investments in digitization and the use of AI and gen AI.

Amit Garg and Marukel Nunez Maxwell are senior partners in McKinsey’s New York office, Marti Riba is a partner in the Boston office, Max Flötotto is a senior partner in the Munich office, Oskar Skau is a partner in the Stockholm office, and Matic Hudournik is an associate partner in the Miami office.

The authors would like to thank Alvaro Cubria, Felipe Costa, Jatin Pant, Matthias Lange, Sergey Khon, Shital Chheda, Tim Natriello, Wajid Ahmed, and Zane Williams for their contributions to this report.