Why is the increase in bank stock prices outstripping the increase in bank earnings? The fundamentals would seem to argue for more modest valuations.
The price of any stock depends on company profitability and growth (more precisely, on the return on equity relative to the required return or hurdle rate and the sustainable increase in retained earnings). To maintain their current ratios of market value to book value, the top 50 banks would seem to need record combinations of profitability and growth-for example, an 18% ROE and an 11% annual increase in earnings per share.
Few, if any, of these banks appear likely to attain and sustain these goals.
But, in reality, they may not have to. Part of the market's enthusiasm for banks may be based on the expectation of a continuing decline in required returns resulting from a falling general level of interest rates. And, indeed, if today's rate of inflation can be maintained, the long-term government bond rate will doubtless slide even further than it already has.
Apart from its obvious effects on bank hurdle rates, a falling government rate betokens an economy relatively free of excesses. Such an environment promises lower loan losses and, concomitantly, a diminished volatility of losses. (Historically, the lower the mean of commercial credit losses, the lower is the volatility of losses around that mean, as proxied by the loss standard deviation.)
In consequence, the income stream of banks would become more stable, damping stock-price volatility (bank betas) and thus further depressing required or hurdle rates of return.
The market may also expect that bank mergers will themselves contribute to this decline in hurdle rates. One reason may be that, as banks get bigger, they lend to more borrowers, improving diversification.
However, the impact of increasing borrower populations has thus far been somewhat muted by the fact that most banks, including the largest ones, lend to customers whose business fortunes are reasonably interdependent. In part, this is because even large banks are relatively local institutions, the bulk of whose borrowers share a common vulnerability to regional shocks. In equal part, it is because the banks have been unwilling, for reasons of moral hazard, to use the loan sales market to dilute loan concentrations that result from their inherently limited primary origination capabilities.
Because their borrower populations are both too small and too interdependent, many large banks experience outsize loss volatility. That is, their loss standard deviations exceed that of the banking industry as a whole.
As bank size increases, however, this problem recedes in importance. Eventually, the bank consolidation movement could spawn entities so huge and so omnipresent that the law of large numbers will wring out most of the diversifiable risk in the system, allowing loan-loss volatility to fall to an almost irreducible level.
So the market may be unusually kind to banks not because it expects ROEs to reach and remain at 18% or because it anticipates continued double-digit earnings growth but rather because it feels that the industry can set much less elevated future earnings goals without displeasing shareholders.
For example, if its required shareholder return falls to 11%, a bank can sustain a market multiple of three times book even if it earns just a 15% ROE and grows at 9% a year, which, incidentally, about matches the growth recorded by the top banks during the 1979-1997 period.
While the market may be bidding up bank stocks for the above reasons, which are essentially defensive in that most are linked to risk reduction, it is doubtless also preoccupied with factors that are more traditional and more aggressive. For example, one obvious reason for high stock prices is the celebrated takeover premium.
Historically, takeovers have benefited the shareholders of the acquiree but not those of the acquirer. Mitchell Madison's research shows that the stock performance of those acquiring banks during the 1990-1995 period lagged that of an index of peer institutions.
It follows that the market should be favoring the stocks of potential targets far more than those of the biggest banks-the ones least likely to be bought. That seems to be the case. The stock performance of regional and superregional banks since the beginning of 1997 has been much more impressive than that of the money-center institutions.
Still another aggressive, if misguided, reason for market enthusiasm for bank stocks may stem from confusion about earnings performance. The bulk of recent large-bank deals have been pooling-of-interest transactions, which do not require the surviving bank to amortize the acquisition premium-the difference between the deal price and the fair market value of acquired assets and liabilities. As a result, reported earnings may overstate actual earnings.
This circumstance may confuse managers as much as the marketplace, with singularly unfortunate consequences. If a bank earning a 15% ROE is purchased at, say, a 50% premium over its true discounted-cash-flow value, then, unless something is done to recoup that premium, the acquired institution will ultimately return only 10% to its new owner.
If accounting smokescreens are allowed to obscure this fact, managers may end up paying excessive premiums and not doing enough to earn them back, thereby contributing to deal failures. Preliminary evidence suggests that this might indeed be happening. Across all industries, pooling-of- interest transactions are substantially more likely to disappoint shareholders than are straight purchases.
Finally, and more positively, the market may be bidding up stock prices because it anticipates a reversal of declining bank market shares.
Size is supposed to equate to strength. While this may not always follow, it is certainly true that a large number of merged institutions now have the resources and the economies of scope (not scale, which they already had enough of before recent mergers) to build much improved brand images.
Those institutions that decide to devote the very considerable resources required to create appropriate brands may be able to win the kind of customer acceptance that allows them to charge premium prices while still recapturing share of wallet from nonbanks. Such a hope merits a stock-price boost.
It may merit more if, as an integral part of their brand-building programs, banks can transform themselves from product-based mass marketers to customer-focused interactive marketers.
The credo of the latter can be summarized as follows: "I am not going to bombard customers with unrelated product offerings. Instead, I am going to use the data base to uncover the holistic needs of customers, test-market 'value propositions' that cater to these needs, vary the content of these value propositions based on customer reactions to these tests, and then roll out revised and successful value propositions to those with the same data base characteristics as the test subjects."
Those banks that best understand this credo and can reshape their organizations to nurture it will be able to both raise net interest income (now under pressure at most banks) and increase fee income sufficiently to more than justify the market's currently high opinion of them.
They will remain beneficiaries of all the purely defensive reasons for high stock valuations while fully exploiting opportunities for aggressive revenue enhancement.