BankThink

Growth Plans Are a Bad Response to Weak ROE

Banks experienced a difficult first quarter with continued weak earnings and stock prices. Especially concerning is sluggish revenue growth at many institutions. Explanations for these results include a low-growth economy and an unfavorable regulatory environment, both of which are likely to continue. Some analysts are even pushing for high-risk transformational change to restart growth. Consequently, banks are under increased pressure, real or imagined, to grow either organically or through acquisitions. However, succumbing to the pressure to grow without considering the risks from that strategy can destroy shareholder value.

Banks need to first evaluate the financial viability of their growth strategy to ensure they are not overpaying for growth. Growth is not free; it requires capital, which carries a cost. The evaluation involves comparing the costs of the required capital investments against their expected returns under multiple scenarios. Next, the credibility of projections must be assessed.

Many banks have failed to earn their cost of equity since the financial crisis. Their persistent low return on equity reflects aging business models and unattractive industry dynamics. Growing under these conditions is unlikely to fix the return problem underlying depressed stock prices. Understandably, the market response to most bank growth strategies, particularly acquisitions, is lukewarm at best.

Banks should only grow if there is a reasonable likelihood of ROE exceeding their cost of equity based on believable projections, preferably supported by historical evidence. The chance of a growth initiative succeeding also rises if an institution can achieve and sustain an "economic moat," a term coined by Warren Buffett meaning a business’ ability to hold on to an advantage over its competitors. An example of a moat would be lower cost for offering a product compared to competitors. Growth without a moat is likely to be fleeting once competitors respond.

Many banks will be hard pressed to satisfy this test and therefore should not grow. A better alternative may be increasing ROE through enhanced capital efficiency. Bankers should avoid substituting shareholder financial capital for their intellectual capital to grow. Any excess capital that cannot be profitably reinvested should be returned to shareholders through higher dividends.

Understandably, a stay-the-course approach to ROE may look unappealing to some banks. Most management teams prefer to run larger, growing banks for the prestige and higher compensation. Some may worry that higher dividend payments are a signal to the market of lower expected earnings growth and tired management. The evidence, however, shows a positive relationship between the dividend payout ratio and future earnings growth, possibly because dividends reduce the risk of value-destroying investments in low-return growth initiatives. Additionally, they signal a shareholder-friendly management team practicing sound capital allocation.

Boards must critically examine optimistic and aggressive growth initiatives championed by ambitious executives, consultants and analysts.

Banks need to be self-critical in evaluating their chances of success in following a growth strategy, while realizing that it’s hard to rebound from a growth failure; second acts like Steve Jobs at Apple are difficult to achieve. Usually, the growth efforts launched by boards and executives are based on an unrealistic assessment of their potential. Pre-crisis banking growth illustrates this fact. Growth during that period turned out to be unsustainable based on increased risk taking. It involved borrowing future earnings, the bill for which came due during the crisis years of 2008-2010, with massive chargeoffs.

All growth is not the same, and growth is not always the best way to create value. Frequently, the problem is not growth, but simply returns. Growth without a commitment to careful capital management evidenced by sound dividend policy and an acceptable ROE is a recipe for investor disappointment and shareholder activism.

J.V. Rizzi is a banking industry consultant and investor.

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