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Bangladesh: The next hot spot in apparel sourcing?

Reprinted with permission from McKinsey Quarterly.

Lower costs are an advantage for the country’s ready-made-garment industry, but challenges remain.

In 2010, China dominated European and US markets for ready-made garments, accounting for about 40 percent of the import volume in each region. A recent McKinsey survey, however, found that 86 percent of the chief purchasing officers in leading apparel companies in Europe and the United States planned to decrease levels of sourcing in China over the next five years because of declining profit margins and capacity constraints.

Although Western buyers are evaluating a considerable number of sourcing options in the Far East and Southeast Asia, many chief purchasing officers said in the survey that they view Bangladesh as the next hot spot (exhibit). Indeed, our study of the country’s ready-made-garment industry identified solid apparel-sourcing opportunities there—but also some hurdles.

With about $15 billion in exports in 2010, ready-made garments are the country’s most important industrial sector; they represent 13 percent and more than 75 percent of GDP and total exports, respectively. McKinsey forecasts export-value growth of 7 to 9 percent annually within the next ten years, so the market will double by 2015 and nearly triple by 2020.

Our survey of chief purchasing officers found that European and US companies that focus on the apparel market’s value segment plan to expand the share of their sourcing from Bangladesh to 25 to 30 percent by 2020, from an average of 20 percent now. Midmarket brands, which generate about 13 percent of their sourcing value in Bangladesh, plan to increase that share to 20 to 25 percent over the same period. While growth in current product categories will drive some of the increase, 63 percent of the chief purchasing officers said that they want to expand into more fashionable or sophisticated items, such as formal wear and outerwear.

In our study, all the respondents identified attractive prices as the most important reason for purchasing in Bangladesh. They also said that price levels there will remain highly competitive in the future, since they expect significant efficiency increases to offset rising wage costs. Half of the respondents mentioned capacity as the second-biggest advantage of Bangladesh’s ready-made-garment industry. With 5,000 factories employing about 3.6 million workers (of a total workforce of 74.0 million), Bangladesh is clearly ahead of other Southeast Asian suppliers in this respect. It also offers satisfactory levels of quality, especially in value and entry-level midmarket products.

Five challenges

While Bangladesh presents some distinct advantages for sourcing, our study identified five challenges for apparel companies seeking to do more business there.

Infrastructure

Transportation bottlenecks create inefficient lead times for garments and delay deliveries to customers. This issue will become even more important in the future, since buyers want to source more fashionable products with shorter lead times.

Energy supply is a concern, too—90 percent of the more than 100 local suppliers we interviewed rate it as poor or very poor. The government has prioritized improvement in this area and started to upgrade power systems over the last two years, however.

Compliance

Nongovernmental and other organizations monitor Bangladesh for labor and social-compliance issues. While most European and US chief purchasing officers said in the survey that standards have somewhat or strongly improved over the past five years, they noted that suppliers vary greatly in their degree of compliance. Environmental compliance is just beginning to get attention.

Suppliers’ performance and the skilled workforce

Our study found that the suppliers’ productivity must improve not only to mitigate the impact of rising wages but also to close gaps with other sourcing countries and to satisfy new customer requirements for more sophisticated products. Two other concerns are a lack of investment in new machinery and technologies and the insufficient size of the skilled workforce, particularly in middle management.

Raw materials

Bangladesh lacks a noteworthy supply of natural or artificial fibers, and its dependence on imports creates sourcing risks and lengthens lead times. Compounding the problem is the volatility of raw-material prices over the past few years. The development of a local sector would improve lead times.

Economic and political stability

About half of the chief purchasing officers interviewed stated that they would reduce levels of sourcing in Bangladesh if its political stability decreased. The survey found that political unrest, strikes, and the ease of doing business are top of mind for respondents.

Realizing the potential

The three main stakeholders—the government, suppliers, and buyers—must work together to realize the potential of Bangladesh’s ready-made-garment market. The government’s top three priorities for investment are infrastructure, education, and trade support.

What can European and US buyers do to secure Bangladesh as a sourcing powerhouse? At the highest level, they should review their approach from a full value chain perspective; for example, to increase the supply chain’s efficiency and transparency, they ought to expand their support for lean operations and electronic data exchange. Buyers should also build closer and long-term relationships with suppliers and, if necessary, rethink pricing negotiations with them. The most developed suppliers are choosing their customers more carefully and even breaking off ties with long-established ones.

Buyers must also improve their own operational execution. Their long response times, the complexity of internal procedures involving the merchandising and sourcing functions, and a high number of last-minute changes slow down the overall process. In addition, buyers must actively pursue compliance efforts.

The full report, Bangladesh’s ready-made garments landscape: The challenge of growth (PDF), is available on the McKinsey & Company Web site.

Language Concentration in USA

 

 

Languages spoken at home are not evenly distributed throughout the nation. Some areas have high percentages of speakers of non-English languages, while others have lower levels.

The percentage of people who spoke a language other than English at home varied substantially across states; just 2 percent of West Virginians 5 years old and over reported speaking a language other than English at home, while 43 percent of people in California reported the same. Moreover, Figure 3 shows that relatively high levels of other language speakers were common in the Southwest and in the larger immigrant gateway states of the East, such as New York, New Jersey, and Florida. With the exception of Illinois, relatively lower levels of foreign-language speakers prevail in most of the Midwest and in the South.

Quite often, concentrations of specific language groups were found in certain areas of the country. In the short term, the factors creating these concentrations include points of entry into the United States and family connections facilitating chain migration (Palloni, et al. 2003). In the longer term, internal migration streams, employment opportunities, and other family situations help to facilitate the diffusion of language groups within the country.

These maps show the percentage of people 5 years old and over in each state who spoke Spanish, French, German, Slavic languages, Korean, Chinese, Vietnamese, and Tagalog.

For Spanish speakers, three states (Texas, California, and New Mexico) were in the highest interval, but the southwest corridor of the United States also had a sizable percentage of the population speaking Spanish (see Figure 5a). Louisiana and Maine had the highest percentage of French speakers, but Florida and many states in the Northeast had a substantial percentage as well. The presence of French Creole speakers in Louisiana and of Haitian Creole speakers in Florida contributed to the higher levels of French speakers in these states.

German speakers spanning the Canadian border of the United States, with the highest percentages in the Dakotas. Pennsylvania had a sizable number of speakers of Pennsylvania Dutch, which is a West Germanic language. Indiana, with a relatively large number of people of German ancestry, also had a high percentage of German speakers. Slavic languages, which include Russian, Polish, and Serbo-Croatian, had the highest percentage of speakers in Illinois, New York, New Jersey, and Connecticut. A substantial level of Slavic speakers also was found n the West Coast states.

Emerging market growth strategies, practices and outlook

Emerging Market Growth

Emerging Market Growth

Reprinted with permission from Deloitte.

In mid-2011, Deloitte Consulting LLP conducted a survey of 628 executives to understand where they perceived the greatest revenue opportunities in emerging markets, which growth strategies have proved most effective and the challenges companies face. The survey respondents included 389 executives from companies that currently generate revenues from one of 10 key emerging market countries or regions.

The companies surveyed found the greatest success in emerging markets came not from simply establishing a sales office and selling their existing products and services. Instead, these companies came to understand the special requirements of customers in each emerging market and then designed offerings to meet their needs at market-appropriate prices. A key ingredient in success was to establish company-owned production, service, distribution, R&D and other operations in emerging markets to become closer to customers and part of the local business community.

Executives saw the greatest opportunities and strategies in the following:

  • Opportunities remain in the BRIC (minus Russia). Among 10 leading emerging markets, executives surveyed were most likely to expect revenue increases of 25 percent or more over the next three years in Brazil, India and China.
  • Bigger is better. According to respondents whose companies had revenues of $5 billion or greater—those larger companies were more likely to have exceeded their sales revenue goals in emerging markets over the last three years, while small companies (less than $500 million in revenue) were the least likely to have done so.
  • Go local. Companies that had company-owned operations in at least five of six major emerging markets were much more likely to have exceeded their revenue goals. In addition, some successful strategies were using local sales/service centers, employing company-owned sales and distribution and employing a company-owned supply chain. Local operations may provide advantages such as greater knowledge of customer needs and buying habits, greater brand awareness in the market and more experience in navigating government approvals and procedures.
  • Know your customer. Designing products specifically for customers in the local market and offering a different value proposition were considered as among the most successful strategies. When it came to challenges identified by survey participants, one of the top challenges in five of the six emerging markets studied was to provide products/services that meet customer needs at prices they can afford.

For many companies, the opportunity in emerging markets is significant, but the challenges can be daunting. Driving growth in emerging markets has fundamental implications for a company’s business strategy, operating model and risk management capabilities – now as well as in the future. While organizations should not embark lightly upon their emerging market journey, the lessons learned from this survey – both successes and failures – can help organizations build more sustainable platforms for growth in emerging markets.

Taking Vietnam’s economy to the next level

Reprinted with permission from McKinsey Global Institute.

During the past quarter century, Vietnam has emerged as one of Asia’s great success stories. In a nation once ravaged by war, the economy has posted annual per capita growth of 5.3 percent since 1986—faster than any other Asian economy apart from China. Vietnam has benefited from a program of internal restructuring, a transition from the agricultural base toward manufacturing and services, and a demographic dividend powered by a youthful population. The country has also prospered since joining the World Trade Organization, in 2007, normalizing trade relations with the United States and ensuring that the economy is consistently ranked as one of Asia’s most attractive destinations for foreign investors.

The McKinsey Global Institute (MGI) estimates that an expanding labor pool and the structural shift away from agriculture contributed two-thirds of Vietnam’s 7 percent annual GDP growth from 2005 to 2010.1 The other third came from improving productivity within sectors. But the first two forces have less and less power to drive further expansion. According to official Vietnam statistics, growth in the country’s labor force will probably decline to about 0.6 percent a year over the next decade, down from 2.8 percent between 2000 and 2010. Given the past decade’s rapid rate of migration from farm to factory, it seems unlikely that the pace can accelerate further to raise productivity enough to offset the slowing growth of the labor force.

Instead, Vietnam should increase its labor productivity growth within sectors to achieve an economy-wide boost of some 50 percent—to 6.4 percent annually—if the economy is to meet the government’s target of a 7 to 8 percent annual GDP expansion by 2020. Without such an increase, we estimate, Vietnam’s growth will probably decline to about 5 percent annually. The difference sounds small, but it isn’t: by 2020, Vietnam’s annual GDP will be 30 percent lower than it would be if the economy continued to grow by 7 percent.

Achieving 6 percent–plus annual growth in economy-wide productivity is a challenging but not unprecedented goal. Nevertheless, incremental change will not achieve a revolution of this magnitude. Deep structural reforms within the Vietnamese economy and a strong and sustained commitment from policy makers and companies will be necessary (see sidebar, “An agenda for sustaining growth”). Also, many companies have prospered in Vietnam because of the country’s strong and stable growth and inexpensive, abundant labor. In the future, they may no longer be able to rely on either, so they will need to ensure that their business and financing models are sufficiently robust to withstand a period of lower growth and, perhaps, economic volatility.

The challenges facing Vietnam

In the near term, Vietnam must cope with a highly uncertain global environment. The economy faces a state of heightened risk because of macroeconomic pressures, including inflation that has built up as a by-product of the government’s efforts to maintain robust growth despite the global economic crisis. In early 2009, Vietnam’s global trade and foreign direct investment declined dramatically, and while exports have recovered, the future of these two sources of economic activity is quite uncertain. The slow recovery of the United States and Europe, together with the nuclear disaster in Japan, has created additional near-term uncertainty. In response to the global economic downturn, the Vietnamese government relied on expansive macroeconomic policies that have led not only to inflationary pressures but also to budget and trade deficits and unstable exchange rates. Some signs suggest that the financial sector is under stress, and international credit-ratings agencies have lowered their ratings on Vietnam’s debt.

In the longer term, Vietnam has a larger challenge. Since the key drivers that powered its robust growth in the past—a young, growing labor force and the transition from agriculture to manufacturing and services—are beginning to run out of steam, Vietnam now needs new sources of growth to replace them. The demographic tailwind responsible for driving a third of Vietnam’s past growth is slackening. Some companies already report labor shortages in major cities. By 2020, the share of the population aged 5 to 19 is projected to drop to 22 percent, from 27 percent in 2010 and 34 percent in 1999. Although Vietnam’s median age, 27.4 years, is still relatively young compared with that of countries such as China (35.2), its population is also aging.

According to government projections, Vietnam’s labor force is likely to grow by about 0.6 percent a year over the next decade, a decline of more than three-quarters from the annual growth of 2.8 percent from 2000 to 2010. Growth in the labor force will still make a positive contribution to GDP, but notably less than it did in the past decade. Vietnam’s growth has also been propelled by extraordinarily rapid migration from rural areas to towns—from relatively low-productivity agriculture to the relatively higher-productivity services and manufacturing sectors. Economic restructuring is unlikely to continue so quickly. Indeed, even aggressive assumptions on the pace of the transition away from agriculture would not compensate for the effects of the decline in overall labor force growth. Without an improvement in productivity growth patterns within sectors, agriculture’s share of the labor force would need to decline at twice the rate of the past decade—unlikely given the aging of rural areas and the decline of agriculture’s share of the total population, by 13 percentage points, over the past ten years.

Vietnam should identify sources of growth to replace those now becoming exhausted. Manufacturing and service industries ought to step up their productivity growth performance. Vietnam could also further develop the capabilities across all sectors, become increasingly versatile as an environment in which companies can constantly innovate and build on recent successes. Offshore services such as data, business-process outsourcing, and IT appear to be promising areas. Vietnam can establish an enabling environment at the level of individual industries and sectors by enhancing domestic competition and helping industries move up the value chain. Building on its expanded pool of university graduates, Vietnam has the potential to become one of the top ten locations in the world for offshore services. Because state-owned enterprises still have enormous importance, accounting for about 40 percent of the nation’s output, reform of their ownership and management incentives is likely to be crucial, as will the need to improve their overall capital efficiency.

As we have seen, to achieve GDP growth of about 7 percent a year, Vietnam needs to raise annual productivity growth to 6.4 percent. Without such an increase, we estimate, the glide path for Vietnam’s growth would decline to between 4.5 and 5 percent annually, significantly below the 7 percent more typical in recent years and the government’s own target, set at the 11th National Party Congress in January 2011, of 7 to 8 percent annual GDP growth to 2020. If growth indeed slows to 4.5 to 5 percent a year, the implications would be significant. By 2020, Vietnam’s annual GDP would be 30 percent (some $46 billion) lower than it could be with 7 percent annual growth. Assuming no shift in the structure of the economy as a whole, we estimate that private consumption would be $31 billion lower. Vietnam’s economy would take 14—rather than 10—years to double in size.

Implications for companies

The exposure of companies and investors to different economic growth outcomes clearly depends on whether they are active primarily in the domestic or export market. Domestically oriented companies, such as those in the financial-services or retail sectors, are much more threatened by slower growth in Vietnam than are companies that use the country as an export base for manufactured goods. Since prospects for growth vary substantially from sector to sector, each company must understand and manage its own specific problems. The expected slowing in the expansion of the labor force also has significant implications for companies. Those that view Vietnam primarily as a low-cost economy with an abundance of workers need to adjust their thinking.

Multinationals

Primarily to hedge their exposure to China, many multinational corporations have opened facilities in Vietnam (or plan to do so), without adequately assessing the prospects, both positive and negative, for expanding business in Vietnam itself. These companies should avoid locking in excess capacity—the country’s economy may not match the strong growth trends of the past—and ensure that their Vietnamese business models are sustainable even if wages rise substantially. Anecdotal and survey evidence consistently indicates that the wage cost advantage is eroding. Much as domestic and export-oriented companies must boost their productivity to be competitive, so too must multinationals, which could also engage with the government to remove barriers to initiatives that clearly benefit both sides, such as programs to increase capital intensity and improve training.

Training is especially important. Multinationals complain about a lack of basic work readiness among new recruits in both the manufacturing and service sectors. Many companies in other countries have responded effectively to this problem by providing in-house training both before an employee starts working and on the job. Surveys suggest that Vietnam has an even bigger shortage of qualified engineers and middle managers than other rapidly developing economies do. Multinational companies can work with the government and educational institutions to address this skill gap. If the Vietnamese government were to issue certificates for qualified training programs, companies might feel more confident in providing such training.

Private-sector Vietnamese corporations

Improving competitiveness and using the latest global best practices should be priorities for Vietnamese companies in the private sector. They should emphasize long-term value and bottom-line profits rather than merely seeking to increase top-line revenue. Too many domestic Vietnamese companies spend too much energy competing on price and too little on product quality, features, and branding and on developing unique offerings that can command premiums.

These companies must develop programs to recruit employees and train them so that their skills and productivity improve. They should also take a more professional approach to retaining and promoting their best workers, through incentive packages and greater management autonomy. The notion of increasing the value of each employee’s performance is not yet widely understood among major Vietnamese companies. Family-owned businesses, which remain a major part of the economy, have thus far tended to resist efforts to improve their governance.

State-owned enterprises

More limited access to capital and increasing competition mean that state-owned enterprises must lift their productivity before circumstances force their hand. Improved management and better governance could raise their competitiveness and overall growth potential. In China, for instance, the significant gains in productivity that resulted from reform within the state-owned sector led to increased profitability as well.

Vietnam’s state-owned companies will also need to recognize the gaps in their pool of talent and to recruit top-drawer, internationally trained executives to help them become more globally competitive. They will increasingly have to benchmark themselves against the best international competitors not only to measure internal operations but also to create realistic plans for expansion and product development.

In this context, the adoption of international accounting standards will support the creation of the detailed performance benchmarks required to identify areas for improvement. Many maturing state-owned enterprises will have to make hard decisions about which businesses should remain core and which should be exited because they can no longer be profitable.

Selling shares in these companies remains a focus of many policy conversations in Vietnam. But most of the sales carried out to date haven’t fundamentally tackled the efficiency problems, because the state typically remains the controlling shareholder. More aggressive steps toward fuller privatization and improvements in the governance of state-owned businesses might help them adjust more rapidly to an era of increasingly vigorous international competition.

We think Vietnam can act decisively to head off short-term risks and embrace a productivity-led agenda. If the country does so, it can build on its many intrinsic strengths—a young labor force, abundant natural resources, and political stability, to name a few—to create a second wave of growth and prosperity. There are challenges, to be sure, but we believe that they can be overcome.

What’s ahead for banking in Eastern Europe

Reprinted with permission from McKinsey Global Institute.

Banks in Eastern Europe have had a roller coaster ride over the past decade.1 After dizzying growth between 2000 and 2007, when shares in the region’s top financial institutions performed better than those of their counterparts around the world, asset values slumped by two-thirds as the credit crisis of 2008–09 took hold. More recently, a modest recovery in sentiment—pinned on hopes that the sector could reestablish itself as the engine of regional economic development—has snagged on wider global worries over sovereign debt.

While this volatility will continue and the region will remain vulnerable to external factors, we expect further long-term growth opportunities for the banking industry in Eastern Europe once the current turmoil has subsided. A new McKinsey analysis—based on empirical data, proprietary benchmarking, and interviews with 20 leading bank executives—identifies a number of segments and geographies that look promising over the next decade. It also highlights strategic actions that successful regional players must take to capture these opportunities.

Projections and figures in this article assume a consensus base case built analytically from the midrange of external macroeconomic forecasts and a consensus view on regulatory and market trends. In general, these assumptions are sluggish global growth, a prolonged and painful deleveraging, and high volatility for the next five years. This is not a worst-case scenario, though, and it does not assume, for example, a disorderly breakup of the EU Economic and Monetary Union (EMU) or a fiscal crisis in the United States.

Broadly speaking, the region’s banks must do two things. First, they must acknowledge the lessons of the past, notably by tackling the problems of insufficient scale, inefficient operating models, and relatively weak risk and governance processes that hobbled efforts to create value in the boom years. Second, they must position themselves to confront a number of fresh challenges, including new regulations, higher funding and risk costs, and changing customer behavior.

In the face of these obstacles, some international banks that owned subsidiaries or branch networks in the region have already exited. We expect this trend to continue or even accelerate when capital markets stabilize, as players reassess their long-term commitment. Banks willing to stay the course and able to adjust their operating models, however, can reap considerable benefits as the region’s economies continue to catch up with those of Western Europe.

The years of missed opportunity

The opportunity to reach new banking customers, combined with the prospect of at last closing the historical gap between Eastern Europe’s economic performance and that of Western Europe, provided the impetus for growth in the region’s banking sector over the past decade.

In 2000, banking penetration in Eastern Europe (as measured by the ratio of lending volumes to GDP) was below that of other emerging markets, such as Latin America or China, in several product categories. Along with low funding and risk costs, this gap created the conditions for a substantial increase in demand for banking services.

Our analysis shows that Eastern European banking revenues from loans and deposits (excluding Russia) grew by more than 14 percent a year on average between 2000 and 2007—more than triple the global average of 4.1 percent and surpassing even China and India during this period. Some products performed particularly well: for example, revenues from mortgages rose between 50 and 100 percent annually, achieving revenue margins of 4 to 5 percent, as well as a return on equity of roughly 100 percent.

Despite the favorable climate and investor optimism, only a few banking groups captured the tangible benefits of expansion. Our analysis shows that between 2004 and 2007, the average level of value creation (defined as returns on equity less cost of capital) at Eastern Europe’s top banks was just 0.2 percent, falling to –2.0 percent for the period from 2004 to 2009. These averages concealed considerable variations—the best performers from 2004 to 2009 created 3.5 percent a year of new value; the worst lost 11.2 percent annually.

This performance paradox—phenomenal growth and juicy product margins coupled with low profitability—can be attributed largely to the costly operating models that banks rolled out across the region. The delivery models were mostly the same as those in Western Europe, even though volumes per customer in Eastern Europe are roughly one-fourteenth of Western European levels, according to our estimates, and disposable incomes are one-fifth as big. Most banks pursued country-by-country entry strategies, in many cases creating a patchwork of subscale, fragmented operations. Governance focused mainly on country-level performance, allowing banks to extract only limited synergies from their portfolios. And assumptions about currency and regional economic convergence were often too optimistic. The financial crisis of 2008 and 2009 laid bare the fragility of the banks’ business models, exacerbating these inherent performance issues.

A challenging decade ahead

Looking forward, Eastern Europe’s fortunes are tied closely to other parts of the world, and the fallout from the sovereign-debt crisis is likely to hit the region hard. That said, the fundamentals for strong economic growth—rising consumption, trade, and investments, as well as the planned accession of more countries to the European Union and monetary association, subject to the euro’s future—are in place. The growing concentration of consumption and wealth in a handful of cities and regions, the need for improved infrastructure, the rise of more affluent consumers, and other important trends will create an impressive economic tailwind to support the growth of banking revenues.

Over the 2010–20 period, we expect those revenues (after loan losses) to increase by an average of 12 percent annually, probably the world’s highest level during these years. Unlike the last decade—when a rising tide lifted all boats—in the future, growth will probably be uneven, concentrated in certain geographic, demographic, and industry pockets.

The banks’ biggest coming challenge, which will be considerably greater than it was in the last decade, is to deliver shareholder returns that exceed the cost of capital. Our market modeling points to a decline in returns on equity from an average of 17 percent (2000–07) to about 13 percent (2010–20). Higher capital requirements, funding costs, and risk costs, as well as new regulations and state interventions and a generally more competitive market, are all likely to weigh heavily on the leading players.

What winning banks must do

How can a banking group outperform in such a challenging competitive, regulatory, and funding environment? What will be the major differentiators between good and bad performance in the next decade? And what will be the best ways to capture the opportunities that will create new value? Our analysis and industry survey results suggest that banks in the region must pursue four strategies.

Reshape business portfolios

Critical mass allows banks to capture scale advantages and create additional value. In Eastern Europe, where costs are high relative to customer volumes, this is especially important. Only a few top banks have been able to build a consistent, sufficiently large portfolio across major markets. In practical terms, this means about a 10 percent share of all markets where such players operate, Russia apart. Recent experience shows that banks at or above this threshold tend to outperform others in value creation: an average return on capital that’s 5.2 percentage points higher than the rest, according to our survey. Our analysis suggests that further acquisitions or swaps of “stuck in the middle” assets could generate incremental returns on equity of two to four percentage points for a number of regional players. If mergers and acquisitions are not possible, another option would be partnerships in, say, product development or distribution.

Build stronger regional-governance models

Successful players must perform a delicate balancing act: on the one hand, to pursue efficiencies by centralizing and standardizing; on the other, to generate value by allowing local units flexibility in managing their business.

One legacy of the past decade has been how most regional groups permit local units to lead stand-alone operations. In the future, finding centralization opportunities and developing standard products or processes through regional operating hubs could drive value, as banks in emerging markets such as Africa have shown. Consolidation is easier in some operations than in others, however. It may be straightforward to centralize international payments, card processing, and custody, for example, but less so the credit processing and IT platforms for deposit and lending products (because of local regulatory requirements).

Develop a differentiated approach to priority segments

The region’s banks must position themselves to take advantage of selected product and customer segments that can serve as growth engines for the next decade. This approach might involve developing a distinctive value proposition for a well-defined segment of sufficient size or pursuing a specialized opportunity such as infrastructure finance.

For example, the “emerging affluent” segment—young, educated, and consumption-oriented urban professionals—could account for up to a third of all retail-banking revenues in the coming three to five years: Eastern Europe, with just 7 percent of the total population of emerging markets, already accounts for 41 percent of all middle-class households in such markets around the world. Emerging affluents exhibit similar behavior patterns across the region. They are tech savvy, preferring online-banking and smartphone applications; reluctant users of branches; and price conscious and service oriented.

To capture this potential, banks must learn to better understand the needs of customer subsegments and put in place differentiated value propositions and service models rather than traditional one-size-fits-all approaches. Affluent customers expect a distinctive experience, yet we find they are frequently disappointed because instead they get the service that banks deliver to the mass market.

Focus on innovation

In the past decade, most banks in Eastern Europe based their home market models largely on the traditional branch networks in Western Europe. In these years, we observed far more banking innovation elsewhere in the emerging world, where low income levels made traditional models unfeasible. Banks in Eastern Europe must now take their cue from other emerging markets and try to develop business models more compatible with their stage of development. This effort might include focusing on “frugal” innovation—reassessing costs from a zero base—and considering greater centralization and the outsourcing of distribution and support. Eastern European banks also have big technological opportunities, including the introduction of richer features for automated teller machines and point-of-sale devices, biometric identification, and mobile payments.

Notwithstanding the industry’s gloomy global outlook, banks in Eastern Europe, including Russia, can prosper in the next decade if they learn the lessons of the past and prepare for new challenges ahead. Those that can reshape their portfolios, target priority segments, build stronger regional-governance models, and innovate successfully are the most likely to boost market share, efficiency, and profitability.