Where next for the banks?
0There is considerable optimism now expressed about the banking sector, with some commentators noting that banks should be a high-beta play on stabilizing economic indicators, with investors underweight, relative earnings momentum perhaps troughing, banks’ share of market cap close to 20-year lows, and some measures of bank risk back to recent lows. But there remain considerable risks.
A quick check of valuations suggests that European banks presently trade on 0.8x tangible book. With estimated cost of equity of 11% and assumed long-run nominal growth of 3%, banks look to be priced for a return on equity of 9.4%, compared with a return of tangible equity of around 11% for US banks between 1960 and 1990, the long period before the extended borrowing binge commenced in earnest. If we assume that banks can achieve returns in line with this historical average, this suggests that banks trade on a 20% discount to fair-value. But in wondering if this is sufficient to accommodate the risks and uncertainties, cost of equity is a key consideration. At its recent investors presentation, Barclays said that the cost of equity was 11.5%, but if the cost of equity was 12%, the discounted mid-cycle return on tangible equity (RoTE) would be 10.2%, and according to the Bank of England, UK banks have never seen a 10-year average RoE above 10% during the period between 1920 to 1990. Thus, it could be that banks are actually marginally expensive with a warranted price to tangible book multiple of 0.78x despite the considerable risks that remain. This doesn’t mean that share prices can’t rise and overshoot fair-value but it may be noteworthy that since the 2008 market downturn, the sector has peaked at an average multiple of 1.3x – yet each peak has seen a lower subsequent peak multiple, with the February peak at 1x tangible book. Ordinarily we might seek comfort on banks’ views on their own mid-cycle earnings power from their boards’ dividend policies, but on a dividend yield relative basis, the sector looks unattractive and there are still more fundamental risks in banks than for almost any other sector.
In thinking about the risks, the policy agenda will likely not be helpful because neither governments nor regulators want banks to be too large with European bank assets at c330% of GDP compared with 80% in the US. We should therefore expect policies to reduce their size. Size is one thing, reliance is another, and 83% of lending to European corporates is presently via banks compared to just 17% of lending to US corporates. This raises sensitivity and national regulators may elect to set tougher standards than Basel 3, with the Bank of England’s Andrew Haldane commenting at Jackson Hole that a minimum leverage ratio (capital over gross assets) of 4% to 7% would have been required for banks to survive the financial crisis, rather than the 3% that Basel 3 rules are targeting. Meanwhile European banking union is not straightforward – whilst the ECB wants to regulate all 6,000 banks by January 2014, the resolution and deposit guarantee scheme have, to our knowledge, not even reached the planning stage and it looks as if the potential capital shortfall for European banks could be over €130bn for end 2012 and close to €60bn for end 2013. This can be part met by reducing assets, but the risk is that banks will sell some of their better assets too cheaply. New measures on bankruptcy as in Ireland may also affect bank profitability, raising loan loss provisions, and possible new bail-in legislation could push up the cost of capital for the sector, putting further downward pressure on Return on Equity.
As for revenues, as high-yielding assets mature so they will be replaced by low-yielding ones and it is hard to make a spread on deposit business when rates are so low. And even if banks do make substantial profits, governments are likely to want a significant share in special taxes, leaving less for shareholders.
Taking all these factors together, bank shares might reasonably trade 30% ‘cheap’ to compensate for the risks. This would imply banks should trade down to a PTB of c0.7x – meaning that the pro-banks trade on assumed cheapness is most certainly not a free lunch.
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
