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