Bank shareholders suffer while staff “have it good”

The main topics in the media this morning have been centred on the banks – co-operation within Europe, concerns on balance sheets, and an ongoing concern that banks still operate without sufficient regard for risk and shareholders whilst staff have it good.

It is well recognised that Euroland needs political and fiscal integration so that monetary union can work, and it was no surprise that German Finance Minister Wolfgang Schaeuble stated that Germany is open to closer European coordination as part of the agenda to deepen political and economic union and that Euroland needs “a real fiscal union” before joint debt management can be discussed. We’ve also had Chancellor Angela Merkel meeting with Mr Barroso as part of preparation for the EU summit on June 28^th-29^th and saying that Germany was open to discussing more common economic policies as the 17-nation euro region strives for “more Europe, not less…The world wants to know how we see the political union in complement to the currency union…That requires an answer in the foreseeable future and Germany will be a very constructive partner.”

De-leveraging in Euroland is an issue for sovereign states and the banks, which intermediated the expansion of lending and indebtedness and expanded their own balance sheets along the way and just as the sovereign risk issues need a Euroland-wide solution, so it is for the banking problems. As Mrs Merkel has commented, systemic banks may need supervision at the European level to keep national interests from playing too large a role, and so-called banking union as proposed by the European Commission’s Mr Barroso consists of three elements: a central banking oversight body; deposit guarantees; and development of national bank restructuring facilities into more of a European network.

Talk of deposit guarantees in effect funded by bank levies raises the challenge of risk control and disclosures, and Andrew Haldane, the Bank of England’s executive director for financial stability has written in this month’s edition of Economia that Britain’s accounting rules were so badly flawed that getting an accurate view of a bank’s assets was like trying to “pin the tail on a boisterous donkey”. He argues that Britain needs separate accounting rules for banks to allow investors and regulators to properly evaluate risks, and International Financial Reporting Standards (IFRS), which set accounting methodology, give a “hit and miss” view of the solvency of banks.

International accounting standards for banks also were highlighted by PIRC today, which revealed that it has analysed the 2011 accounts of the UK’s top five banks to calculate how much they expect to write off as bad debt in the coming years but have yet to take against profits. PIRC state that UK banks sit on £40bn of undeclared losses, with Royal Bank of Scotland in worst condition, with £18bn of undeclared losses, which would wipe out more than a third of its capital buffer and potentially force the company back to the taxpayer for another rescue. HSBC had £10bn in undeclared losses, Barclays £6.7bn, Standard Chartered £3.6bn and Lloyds Banking Group £3.6bn. Apparently PIRC presented its numbers to all the banks and none disputed them and PIRC argue that the rules prevent provisioning against potential losses, “masking the true position [of the accounts] by including fictional assets and fictional profits”. It added that dividends and bonuses are being paid out on inflated profit numbers, when they should be retained to boost the banks’ capital cushions.

If that wasn’t enough, the Financial Times today published a report that the world’s big international banks are paying out much more on staff costs relative to profits since the financial crisis while cutting the portion of income paid out in dividends. The FT data measured trends at 13 international banks, examining the proportion of an overall pot comprised of net profits and staff costs, allocated three ways: to dividends, staff costs and retained earnings. Dividends represented just 4.5% of the allocation last year, down from nearly 15% in 2006, the last full year before the onset of the financial crisis. At the same time, staff costs accounted for more than 81% of the total, compared with a pre-crisis tally of 58%. Aggregate staff costs have increased at an average annual rate of 7% to hit $259bn last year. Over the same period, the banks’ share prices have fallen almost 60%. Aggregate dividends for 2011, at their lowest level since the FT data begins in 2000, amounted to $18bn, compared with the 2007 peak of $61bn. All 13 banks paid a greater proportion of the pot to staff costs last year than in 2006, with the proportion doubling at two of the banks hardest hit by the crisis – Bank of America and Royal Bank of Scotland. That’s the sort of news to whip up dissent but losses at both banks have distorted the figures, while BofA’s number is also inflated by its takeover of Merrill Lynch.

It’s clear that banks need to consider the appropriate split between staff and investors, risk and return, and their moral compass. So it was today that the media also focused on the news that 20 bankers and ex-managers of UniCredit, Italy’s biggest lender and of Barclays have been charged with fraud in a tax probe linked to an investment plan known as Brontos. The case is complex and UniCredit has said the bank and its employees “acted with transparency and in good faith” and there’s the underlying challenge as to the agenda that a bank should follow. Pilloried for seeking to maximise shareholder value by sailing close to the wind, pursuing fat margins on loans vs deposits, and declining loans as balance sheets shrink, whilst being decried for failing to make adequate returns on risk capital, it’s apparent that banks face a regulatory-constrained outlook in which loans continue to shrink, and deposits must grow. But in this environment asset spreads can expand and costs/impairments fall, such that profits grind higher. There may also be greater-than-expected deleveraging of risk positions. But this is not a ‘no lose’ situation – accelerated de-leveraging should hasten the return to ‘business as usual’, but it also threatens to undermine ‘normalized’ earnings power.

We should be mindful of this risk and keep an eye on the pace and scale of risk asset shrinkage, funding costs and efficiencies – both of which carry upside risk and are as important determinants of earnings power as balance sheet size, and we must also monitor any trade off between reducing dilution risk and safeguarding earnings power.

In focusing on equity return prospects, the reasonable points of attention are steady state return on equity particularly relative to cost of equity and the steady state level of returns. There will be winners in a world where bank balance sheets are reduced, and banks take less risk. Strategic vision is crucial and given that extraordinary price movements are where consensus is wrong-footed, we also need to see opportunities where all the bad news and more is in the price and where positive prospects are poorly understood but real and imminent. There are banks that fit the bill – but plenty more that represent unwarranted, uncompensated and unjustified risks to trap the unwary. For now investors and lenders should want robust balance sheets, high levels of sustained profit and profitability and conservative business practices. De-leveraging episodes do evolve into more positive climates – but we are not there yet in Euroland.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange
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