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Understanding social media in China

The world’s largest social-media market is vastly different from its counterpart in the West. Yet the ingredients of a winning strategy are familiar.

Reprinted with permission from McKinsey Quarterly

No Facebook. No Twitter. No YouTube. Listing the companies that don’t have access to China’s exploding social-media space underscores just how different it is from those of many Western markets. Understanding that space is vitally important for anyone trying to engage Chinese consumers: social media is a larger phenomenon in the world’sa second-biggest economy than it is in other countries, including the United States. And it’s not indecipherable. Chinese consumers follow the same decision-making journey as their peers in other countries, and the basic rules for engaging with them effectively are reassuringly familiar.

Surveying the scene

In addition to having the world’s biggest Internet user base—513 million people, more than double the 245 million users in the United States1—China also has the world’s most active environment for social media. More than 300 million people use it, from blogs to social-networking sites to microblogs and other online communities.2 That’s roughly equivalent to the combined population of France, Germany, Italy, Spain, and the United Kingdom. In addition, China’s online users spend more than 40 percent of their time online on social media, a figure that continues to rise rapidly.

This appetite for all things social has spawned a dizzying array of companies, many with tools more advanced than those in the West: for example, Chinese users were able to embed multimedia content in social media more than 18 months before Twitter users could do so in the United States. Social media began in China in 1994 with online forums and communities and migrated to instant messaging in 1999. User review sites such as Dianping emerged around 2003. Blogging took off in 2004, followed a year later by social-networking sites with chatting capabilities such as Renren. Sina Weibo launched in 2009, offering microblogging with multimedia. Location-based player Jiepang appeared in 2010, offering services similar to foursquare’s.

This explosive growth shows few signs of abating, a trend that’s at least partially attributable to the fact that it’s harder for the government to censor social media than other information channels. That’s one critical way the Chinese market is unique. As you shape your own social-media strategy, it’s important to fully understand some other nuances of the country’s consumers, content, and platforms.

Consumers

China’s social-media users not only are more active than those of any other country but also, in more than 80 percent of all cases, have multiple social-media accounts, primarily with local players (compared with just 39 percent in Japan).3 The use of mobile technologies to access social media is also increasingly popular in China: there were more than 100 million mobile social users in 2010, a number that is forecast to grow by about 30 percent annually.4 Finally, because many Chinese are somewhat skeptical of formal institutions and authority, users disproportionately value the advice of opinion leaders in social networks. An independent survey of moisturizer purchasers, for example, observed that 66 percent of Chinese consumers relied on recommendations from friends and family, compared with 38 percent of their US counterparts.

Content

The competition for consumers is fierce in China’s social-media space. Many companies regularly employ “artificial writers” to seed positive content about themselves online and attack competitors with negative news they hope will go viral. In several instances, negative publicity about companies—such as allegations of product contamination—has prompted waves of microblog posts from competitors and disguised users. Businesses trying to manage social-media crises should carefully identify the source of negative posts and base countermeasures on whether they came from competitors or real consumers. Companies must also factor in the impact of artificial writers when mining for social-media consumer insights and comparing the performance of their brands against that of competitors. Otherwise, they risk drawing the wrong conclusions about consumer behavior and brand preferences.

Platforms

China’s social-media sector is very fragmented and local. Each social-media and e-commerce platform has at least two major local players: in microblogging (or weibo), for example, Sina Weibo and Tencent Weibo; in social networking, a number of companies, including Renren and Kaixin001. These players have different strengths, areas of focus, and, often, geographic priorities. For marketers, this fragmentation increases the complexity of the social-media landscape in China and requires significant resources and expertise, including a network of partners to help guide the way. Competition is evolving quickly—marketers looking for partners should closely monitor development of the sector’s platforms and players.

Crafting a winning strategy

While these unique Chinese market characteristics often create challenging wrinkles for marketers to contend with, they don’t invalidate the principles that underpin effective social-media strategy elsewhere (for more, see “Demystifying social media”). The following few examples illustrate how companies are applying some widespread social-media tenets in China.

Make content authentic and user oriented. Estée Lauder’s Clinique brand launched a drama series, Sufei’s Diary, with 40 episodes broadcast daily on a dedicated Web site. (Viewers also could watch segments on monitors located on buses, trains, and airplanes.) While skin care was part of the story line and products were prominently featured, Sufei’s Diary was seen as entertainment—not a Clinique advertisement—and has been viewed online more than 21 million times. Clinique’s online brand awareness is now 27 percent higher than that of its competitors, although social-media content costs significantly less than a traditional advertising campaign.

Adopt a test-and-learn approach. When Dove China first imported the Real Beauty social-media campaign to promote beauty among women of all looks and body types, Chinese consumers viewed the real women as overweight and unattractive. Dove switched tack and partnered withUgly Wudi, the Chinese adaptation of the US television show Ugly Betty, to weave the Real Beauty message into story lines and mount a number of initiatives, including a blog by Wudi and live online chats. The effort generated millions of searches and blog entries, increased uptake of Dove body wash by 21 percent year over year after the show’s first season, and increased unaided awareness of Dove’s Real Beauty by 44 percent among target consumers. The estimated return on investment from this social-media campaign was four times that of a traditional TV media investment.

Support overarching brand goals with sustained social-media efforts. Starbucks China promotes the same message of quality, social responsibility, and community building across all of its social-media efforts, as well as in its stores. And Durex didn’t just establish a corporate account on Sina Weibo: it built a marketing team that both monitors online comments around the clock and collaborates closely with agency partners to create original, funny content. The company’s approach is designed to interact meaningfully with fans, generate buzz, and deepen customer engagement with the brand.

The sheer number of the more than 300 million social-media users in China creates unique challenges for effective consumer engagement. People expect responses to each and every post, for example, so companies must develop new models and processes for effectively engaging individuals in a way that communicates brand identity and values, satisfies consumer concerns, and doesn’t lead to a negative viral spiral. Another problem is the difficulty of developing and tracking reliable metrics to gauge a social-media strategy’s performance, given the size of the user base, a lack of analytical tools (such as those offered by Facebook and Google in other markets), and limited transparency into leading platforms. Yet these challenges should not deter companies. The similarity between the ingredients of success in China and in other markets makes it easier—and well worth the trouble—to cope with the country’s many peculiarities.

Innovation in Energy – Five technologies to watch

Reprinted with permission from McKinsey Quarterly

Innovation in energy technology is taking place rapidly. Five technologies you may not have heard of could be ready to change the energy landscape by 2020.

Recent breakthroughs in natural-gas extraction highlight the speed with which game-changing technologies can transform the natural-resource landscape. Just over the horizon are others—such as electric vehicles, advanced internal-combustion engines, solar photovoltaics, and LED lighting—that are benefiting from the convergence of software, consumer electronics, and traditional industrial processes. Each has the potential to grow by a factor of ten in the next decade.

Placing rapidly evolving technologies such as these on a resource cost curve, however, is difficult: their impact could be very big or very small. And that’s even more the case for technologies that require significant scientific and engineering innovations to reach commercial scale at viable cost. This article describes five technologies that could start arriving in earnest by 2020 or so: grid-scale storage, digital-power conversion, compressorless air conditioning and electrochromic windows, clean coal, and electrofuels and new biofuels.

Not all of these will succeed in the market; they will earn a place only if they can outperform the rising bar defined by other rapidly advancing technologies. But even if only some of them pan out, those could transform the energy landscape. It’s possible, in fact, that the development of energy technologies is approaching a tipping point that will generate increases in energy productivity on a scale not seen since the Industrial Revolution.

Grid-scale storage. The large-scale storage of electricity within electric power grids allows power generated overnight to meet peak load during the day. Today, this kind of grid storage costs about $600 to $1,000 per kilowatt hour (kWh) and can be used only when the local geology supports pumped-hydro or compressed-air storage systems. Innovations using flow batteries, liquid-metal batteries, flywheels, and ultracapacitors could reduce costs to $150 to $200 per kWh by 2020 and make it possible to provide grid storage in every major metropolitan market. At these prices, by 2020 the United States alone would want to build more than 100 gigawatts (GW) of storage (the capacity equivalent of the current US nuclear-generation fleet).

That much storage capacity would be transformative: currently, our power grid tends to use only 20 to 30 percent of its capacity because we build it to meet very high demand peaks. With storage, we can flatten out those peaks, reducing capital requirements for transmission and distribution and making power much cheaper to deliver. Power companies also could use storage to smooth variability in the supply of weather-dependent renewables, such as solar and wind power, thereby converting them from intermittent power sources into much more reliable ones.

Digital-power conversion. Large-scale high-voltage transformers, developed in the late 1880s, set the stage for the widespread development of the electrical grid. Virtually the same technology is still in use today. A typical transformer costs $20,000, weighs 10,000 pounds, and takes up 250 cubic feet. High-speed digital switches made of silicon carbide and gallium nitride have been developed for high-frequency power management for everything from military jets to high-speed rail. They use 90 percent less energy, take up only about 1 percent as much space, and are more reliable and flexible than existing transformers. Today’s advanced applications include consumer electronics and variable-speed industrial drives for manufacturing. As such applications expand and the major semiconductor manufacturers begin to produce these technologies at scale, they could replace conventional transformers in the utility industry (at less than one-tenth the cost) by 2020. China is particularly well positioned to benefit from adopting digital-power electronics because of the scale of its planned grid expansion.

Compressorless air conditioning and electrochromic windows. Today, it costs about $3,000 to $4,000 a year to run a high-efficiency air conditioner in a hot region, and even the efficient windows now commonly used allow 50 percent of the cooling energy to escape. New compressorless air conditioners dehumidify the air with desiccants rather than the traditional “compress/decompress” refrigeration cycle. Electrochromic window technologies change the window shading, depending on the temperature difference between outside and inside. These technologies offer the potential to cut home-cooling bills in half. Advanced windows also could slash heating costs by half, allowing the sun to warm houses while keeping the cold out—the new windows are often better than the standard attic insulation in cold-climate homes today. These technologies are expensive now, but by 2020 they should cost only about half as much to install as current state-of-the-art cooling and window technologies do.

Clean coal. Today, carbon capture and sequestration (CCS) costs $8,000 to $10,000 per kilowatt (kW). Innovative processes now under development could help coal-fired generators to capture more than 90 percent of their carbon dioxide, at a cost of less than $2,000 per kW. If the technology is viable by 2020, it would be possible for nearly 70 percent of the roughly 200 US coal plants currently slated for closure in that year to stay open for decades. The same goes for similar plants in China and Europe. Without supportive carbon regulations, though, we are unlikely to see clean coal deployed at scale. Coal without carbon sequestration will always be cheaper than coal with it. On current course, though, coal with carbon sequestration could become cheaper, more reliable, and more widely deployable than many renewable technologies.

Biofuels and electrofuels. With crude-oil prices approaching $100 a barrel, market shares for biofuels such as cane and corn ethanol are rising rapidly. Although second-generation cellulosic biofuels have proved harder to make than many had hoped five years ago, innovative start-ups focused on cellulosic and algae-based biofuels are starting to create high-margin specialty chemicals and blendstocks, generating cash now and suggesting a pathway to deliver biofuels at $2 a gallon or less by 2020. At the same time, biopharmaceutical researchers are developing electrofuel pathways that feed carbon dioxide, water, and energy to enzymes to create long-chain carbon molecules that function like fossil fuels at one-tenth the cost of current biofuels. The key question is whether these new technologies can be scaled. If they can, today’s constraints on biofuels—the declining quality of available land and “food for fuel” trade-offs—may diminish.

Many other technologies could play a major role further out in the future, such as small, modular “Gen IV” nuclear reactors; next-generation fusion technology; small, shrouded wind turbine designs; solid-oxide fuel cells; and low-cost ground-source heat pumps. Not all of them will come to fruition, but some will—and those that do could change energy markets dramatically. The rate of change in the underlying technologies is much faster than the market currently expects. Leaders of companies and countries who neglect what is happening on the margins today risk being pushed to the margins themselves in the not-too-distant future.

The Future of Mobile Banking in Latin America

Mobile Banking

Insights from Argentina, Brazil, and Mexico

Reprinted with permission from Deloitte.

Mobile technology offers an unprecedented growth opportunity for retail banking in Latin America. As these economies continue to prosper, increasingly affluent consumers and underbanked1 segments may create demand for new financial products and services. Many consumers in Latin America have mobile phones, but not bank accounts. The mobile channel therefore provides an effective way to attract them into the financial services marketplace.

These favorable attributes represent new opportunities for banks operating in Latin America. According to Deloitte Center for Financial Services2 analysis, within the next several years mobile banking will be more of a necessity than a choice and it will likely become an integral component of a bank’s business strategy. Realizing this, many banks in the region already have developed basic capabilities. Institutions behind the curve may wish to act soon or risk being left behind, and even market leaders may benefit from re-examining their strategies to fully integrate mobile banking into their operations. Those who accelerate their plans and develop innovative strategies could shape the mobile landscape to their advantage.

This paper addresses the current climate, future prospects, and possible challenges to the growth of mobile banking in the region, focusing on Argentina, Brazil, and Mexico. Though the final form may vary locally, we expect a rapid transformation in mobile banking and payments in Latin America throughout the next several years.

The full report can be downloaded from here.

1 In this document, the term “underbanked” refers both to those with limited access to financial services and those with no access at all.

2 As used in this document, “Deloitte” means Deloitte LLP. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting.

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.

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.