by Roy C. Smith
In different articles last year, Brad Hintz and I argued
that the world’s largest capital market banks faced a troubled future, burdened
chiefly by vastly increased regulatory requirements, heavy litigation costs,
pressure on margins, and changes in the trading markets. These burdens resulted in lowered returns on
equity, and higher costs of equity capital, such that the net economic valued
added (EVA) of these firms was negative and had been for several years. Our conclusion was that the banks would have
to substantially restructure their business models to regain economic
viability. The data we used to form our opinion has been consistent since 2009,
but the most recent set was as of Dec. 30, 2015.
Since then, many things have happened. After the election of
Donald Trump as President of the US the S&P 500 stock index rose 17.5%, As
they continually surpassed record levels, stock markets hummed with speculation
about improved economic growth rates, a strong dollar, and a sizeable reduction
in US financial and other regulation.
The banking sector was to be a major beneficiary of these positive
expectations.
Seven of the top ten capital market banks’ stock prices have
gained more than 20% since January 1, 2017, though three (Barclays, Deutsche Bank,
and Credit Suisse) posted declines of
20% or more. The average price-to-book
ratio for the top ten banks in Dec. 2015 was 0.75, at the end of the second
quarter of 2017 it was 0.99; in 2015, the average EVA (the spread between the
banks’ returns on equity and their cost of equity capital) was -8.90%; now it is
-2.16%. Though five of the ten banks were in positive EVA territory, two,
Deutsche Bank and Credit Suisse posted EVAs of -10.3% and -13.4%, respectively).
Banks have benefitted (in their EVA calculations) from the
lowering of their average “beta” (a volatility measure used to calculate cost
of equity capital under the Capital Asset Pricing Method) from 1.72 to 1.38.
Lowered betas are a direct result of reduction in the risk levels of the banks,
which was the main purpose of the increased regulation.
Average returns on equity also improved from 5.36% to 6.64%.
Most of this appears to be due to cost cutting, asset sales, and reengineering
products and trading platforms. Revenues for the top banks were up 4% for the
first two quarters of 2017, but still down 13% from five years ago.
Overall, these data indicate things are getting better for
most of the banks. And, the enormous storm of litigation from financial crisis
misdeeds that weakened returns and book values for the last several years has
apparently run its course. US banks have also done better on the stress tests
and been permitted large increases in dividend payouts and stock repurchases.
However, expectations for an economic boost by reforming
taxes, infrastructure spending and deregulation have diminished significantly –
Republicans are divided and Mr. Trump seems helpless to do much about it.
Whatever does happen will be less impactful, and later in arriving, than was
thought six months ago. Deregulation is limited to executive orders not
requiring Congressional approval, and this, too, has amounted to less than
expected. The SEC produced a report in August that said it was unable to tell
whether the Volcker rule limiting proprietary trading was effective or not,
suggesting it might not be changed. Earlier, a Treasury Department report
required by an earlier executive order only recommended five regulatory reforms
of the most general nature. When and how these might be produced and become
effective is unknown. The Financial Choice Act, meant to neutralize the Dodd
Frank Wall Street Reform and Consumer Protection Act, was passed by the House
of Representatives in June, but has little chance for passage by the Senate
this year. Still, most observers believe that something will happen in the next
year or two to soften Dodd Frank, but probably not anything very meaningful to
capital market banks.
Dodd Frank is vast and very expensive to comply with, but it
is not the chief source of the capital market banks’ regulatory burden. These come from Basel III (a minimum bank
capital adequacy agreement) and the new form of qualitative stress tests that
central banks now impose on their global systemically important banks. Most of
these measures were adopted by the G-20 group of countries with strong US
support.
Basel III effectively doubled the capital adequacy
requirement while halving leverage and requiring capital buffers to insure
adequate liquidity in a time of crisis. This made trading inventories expensive
when trading volumes were soft and margins were under competitive pressure as
they still are. Basel III constraints seriously limited the operating field-of-play
available to banks.
The stress tests were designed to be impossible to “game,”
and the consequences for not meeting them were potentially so severe (in terms
of limiting payment of dividends and stock buybacks) that none of the banks
tried to do so. However, the rules of
the stress tests change without notice, so the banks’ operating areas were
limited further. Even so, some banks (JP
Morgan, Goldman Sachs, and Wells Fargo) , have adapted and been able to
generate minimally satisfactory EVAs under this regime (JP Morgan’s is +3.2%,
modest but acceptable), but others (Credit Suisse, Deutsche Bank, Barclays, and
Citigroup) continue to be unable to do so, despite years of tinkering with
their balance sheets and business models.
One thing that hasn’t changed since Dec. 30, 2015 is the unwillingness
of the struggling banks to break themselves up. That is, into investment banks or
commercial banks in order to specialize in trading and fee businesses, or
deposit taking and lending, two very dissimilar businesses.
We presented a case for such breakups last year – when many
banks were trading well below book value – as a way of recovering shareholder
value. None followed our advice, and now that some banks have seen major
increases in their share prices, it is unlikely they will be interested in
doing so now. But half of the industry is still in big trouble, still trading
below book and earning far less that it costs their investors to hold their
stock.
So, despite some signs to the contrary, nothing really has
changed, or is likely to soon. But our
original argument still seems valid, so there is still a good argument for
breaking up at least some of the worst performing banks. Institutional and activist investors ought to
encourage them to do so.
Published Sept. 13, 2017 in Financial News
