Retail banking in Europe has reached a crossroads. After a decade of strong profits, rising shareholder value, and consolidation in most countries, the sector is in danger of running out of steam. Management teams urgently need to find strategies for growth, either domestic or foreign.

Opportunities abound, but the challenges are considerable. Europe's banks, powered by falling interest rates, healthy economic growth, and strong equity markets, have enjoyed a brisk following wind in recent years, but these advantages are now largely in the past. Meanwhile, the regulatory environment is becoming more turbulent, and consumers are pressuring governments to make banks widen access to their services or even to impose price controls. Furthermore, the possibilities for restructuring through M&A are narrowing. Although some recent mergers—as well as recent Dutch and Spanish moves to bid for banks in Italy—have created strong interest across all European markets, there is no guarantee of a wave of value-creating cross-border mergers.

Interviews with leading bankers, plus an analysis of a range of industry scenarios, suggest that European banks looking for faster growth should concentrate on three areas where they are weak: execution, product innovation, and managing regulation.

Grasping the opportunities

To some extent, unrepeatable factors have driven the past decade's success. Given the level of concentration across most markets, the value created by domestic-consolidation strategies is no longer available. Improvements in credit control, and the resulting reduced credit losses, are hugely important but hard to repeat. Banks have outperformed their close cousins in both the insurance industry and the broader stock markets. Most banks are well capitalized, and the quality of their top management has improved greatly. Yet despite the sector's success to date in delivering shareholder returns, revenue growth remains elusive. Economic theory says that rising GDP per capita should disproportionately drive higher demand for financial services. However, their value added in Europe has actually stagnated at about 5 percent of GDP since the early 1990s (Exhibit 1). Over the same period, the equivalent figure in the United States climbed to 9 percent, from 6 percent.

Barriers to competition in Europe are part of the story. Differences in consumer behavior are also important: US consumers have been willing to borrow more (on credit cards and for home mortgages) than have most of their European counterparts. But the striking difference between the United States and Europe in the sector's growth as compared with the growth of GDP suggests that the more vibrant, competitive, and innovative US market can support higher growth than Europe can. This search for growth lies at the heart of most retail-banking strategies across Europe, and most banks are focusing on similar opportunities (see sidebar "Europe's retail-banking hot spots").

The imperatives

Judging from the results of McKinsey interviews with 20 CEOs and 65 promising middle managers (nominated by their CEOs) from European banks, the industry itself is cautious about the period up to 2010, not least because of the anticipated impact of new bank regulations. Many of the industry's leaders not only expect high costs in implementing the revised capital adequacy standards (Basel II) and in adhering to new International Financial Reporting Standards but also fear a hardening of government attitudes that could lead to price controls and measures restricting rather than enhancing competition. There is also concern about where new sources of growth will come from and about what many leaders see as the unrealistic expectations of investors.

Four possible scenarios suggest what the banking landscape might be in 2010 (see sidebar "Scenarios for European retail banking in 2010"). These range from a pessimistic mix of misguided regulation and falling profitability through quiet evolution in line with current trends to a bright combination of pragmatic regulators, innovative practitioners, and satisfied consumers. Whatever the outcome, banks must shape their strategies along three main dimensions: execution, innovation, and regulation.

Execution and customer service

Great execution involves a mix of cost cutting and quality improvements. Banks must drive down costs year after year to keep ahead of falling margins. They also need to make their sales and service more effective and to minimize their loan losses by eliminating mistakes in lending.

In European banking, labor productivity (measured by the volume of loans, deposits, and transactions relative to employment levels) leaves much to be desired (Exhibit 2). Sweden is an exception, leading the international pack—ahead of the United States, with Belgium and the Netherlands close behind. But banking productivity in the rest of Europe trails best practice by 20 to 50 percent. From 1995 to 2002, the costs of European banks increased by 2.8 percent in real terms, somewhat faster than the 2.1 percent growth in revenues. Some banks have done much better through consolidation, but only 7 percent have reduced their costs and increased their income simultaneously.

Banks will have to embrace radical change in their operations, just as Europe's manufacturing industries did during the 1980s and 1990s in response to East Asian competition. Many banks are already adopting Six Sigma and lean-manufacturing techniques to reduce errors and raise productivity. These techniques offer huge potential benefits but must be implemented carefully and in a way that builds lasting skills and knowledge across all levels of staff. As manufacturing companies found, some experiments with lean techniques and Six Sigma will fail. But banks that get it right will create a significant advantage in productivity and quality.

Offshoring will be an imperative for many banks even though political, cultural, and language barriers limit the ability of continental European institutions to take as much advantage of the possibilities in China or India as their British counterparts have done. Also, banks can significantly raise their domestic productivity through centralization, automation, and continuous-improvement techniques. In countries with an aging workforce—for example, France, where more than 25 percent of branch staff and 40 percent of back-office staff are over 50—banks should be able to reduce head counts.

Banks that haven't centralized and automated their processes must do so. A proven model of success is the manufacturing division—back- and midoffice functions such as IT, the processing of payments and securities, and the development of new products—led by a chief manufacturing officer with a powerful voice in the operating committee. Banks may wish to split the functions of the chief information officer between two distinct roles: one handling technology strategy (IT strategy, architecture, and standards), the other focused on IT support for efficient, low-cost banking operations. To derive value from cross-border M&A, banks will need IT platforms that can accommodate higher volumes and incorporate new features rather than the inflexible legacy systems still prevalent across Europe. The success of most deals will probably hinge more on operational efficiencies than on new revenues or on cost savings achieved through shared distribution channels.

As for customer service, many European banks have fallen short of customer expectation during the past decade. Many bank processes still have 1 percent error rates. If European maternity wards were similarly error prone, they would give 40,000 babies to the wrong parents each year.

Clearly, better service represents a strategic opportunity for bolder players. The head of a leading UK bank recently told the Financial Times that one of the bank's London branches had put up a sign telling passersby that they could call in to collect a free £5 note. Not a single person responded, apparently because no one thought the offer was genuine. That experience graphically exposed the low trust and low satisfaction widespread among customers of Europe's biggest banks. Those that raise their game will win.

Innovative products and marketing

Simplicity, limited choice, and outstanding customer service are the only areas in which many players may choose to compete. These things could suffice for the mass market, but wealthy customers—and certainly those in the savings and investment arena—demand more variety and more innovative products. In this context, better marketing should become a central strategic priority. Inspiration can be found in other businesses that have developed strong brands from seemingly unpromising material. Absolut turned vodka, formerly a dull drink associated with the poor, into a chic cocktail; the morning cup of coffee has become a "drinking experience" in the hands of Starbucks; flat-pack furniture adorns the houses of the affluent and aspiring thanks to IKEA. Banks too must find ways to develop brands commanding loyalty and affection. They should set their sights on joining the marketing elite: companies such as L'Oréal, Mars, Procter & Gamble, and Tesco, which expertly craft products for well-targeted niche groups rather than treating all customers alike.

Banks should invest in every aspect of the consumer experience. They must develop intangible benefits that generate warmth, new perceptions, and a can-do attitude toward the customer's problems. Young families, for example, typically need reassurance when taking out a mortgage; their feelings cry out for an imaginative offer beyond merely providing a loan and a list of repayment options. Too often, banks present products from a technical angle—emphasizing, in the case of investment products, jargon like "caps" or "floors" or the link to stock market indexes, not the benefits and implications for specific customers. Nobody would sell a car by explaining the gearbox or the performance of the tires.

Much as successful retailers present shoppers with a choice of three or four strong brands, each positioned distinctly, banks shouldn't overwhelm customers with choice. Successful marketing companies move quickly to kill products that don't take off. In contrast, many bank portfolios are full of moribund ones that should be culled, as the Italian bank Intesa did recently when it eliminated 80 percent of its offerings.

Managing regulation

Diverse regulatory measures will be implemented during the next five to six years. The scale of these changes is clear, but the nature of their impact isn't: they could be quite positive or damaging. Almost all of the senior bankers interviewed worried about the cost of these measures and the potential for unintended consequences not only on the industry's profitability but also on consumers.

Fatalism doesn't pay, however. On the contrary, CEOs who actively demonstrate a concern for the customer—and the shareholder—should be able to encourage more market-friendly regulation and thus to help create a more profitable European banking environment. This point is hard to prove, but it is implicit in conversations with national banking regulators and with those at the European Commission, which is explicitly promarket and seeks to advance the consumer's interests by promoting competition. The alternative (favored by some consumer groups) is a more interventionist stance likely to stifle initiative and to limit retail banking's growth across Europe.

In our more pessimistic scenario, the industry gets caught in a vicious circle: shortsighted actions by management lead to misguided regulation, which in turn reduces competition and the value consumers get for their money. Consider a recent example from one major European country. A bank's poorly timed and badly explained initiative to charge customers for withdrawals provoked political anger and a parliamentary commission. As a result, the whole industry has been forced to provide unprofitable services. In our more optimistic scenario, we envision a virtuous circle in which European banks act in customer-friendly and value-conscious ways that encourage promarket, pragmatic, and less costly intervention. Some banking leaders shared this positive vision; others felt it was unrealistic, even if desirable.

Compared with industries such as autos, pharmaceuticals, and steel, banks haven't been skilled at influencing politicians and the public through either direct lobbying or more subtle strategies to shape opinion. A broad range of banks participated in the working sessions that led to Basel II, but only a couple of leading European players appear to have been truly influential in shaping the detailed rules. Moreover, the banking industry's efforts in Brussels have been damagingly fragmented—a missed opportunity, though there are now signs that the industry is slowly beginning to mobilize. Contrary to conventional wisdom, the officials of the European Commission generally welcome industry expertise as they develop workable and practical new measures.

Since the future of European retail banking could have such a wide range of outcomes over the next five years, leaders face a difficult challenge in crafting strategy. But whatever the strategic focus of individual banks, several closely linked imperatives apply to all of them. Great execution is important, partly because the productivity of European banks is poor by international standards and because, in the short term, better customer service, more innovation, and greater value for money will further stress margins. Nonetheless, customer service and innovation are urgent priorities in the race to build world-class brands. They also matter because they can help persuade regulators that market-based solutions are in the consumer's best long-term interest.