Not to get too far ahead of themselves, but many industry seers are making back-of-the-envelope calculations for when the banking industry bounces back.
Though they differ when that might be, most agree that when it happens, return on equity will re-enter the conversation and regain ground on tangible common equity ratios as the hot industry yardstick — though at a much lower level than in the good old days.
For years the industry benchmark for return on equity was 15%, but analysts say many bankers would be lucky to achieve a ratio closer to 10%. Still, that would be considerably higher than the average estimate of 4% for this year for banks and thrifts with $1 billion or more of assets, according to Friedman, Billings, Ramsey Group Inc.
The lower target reflects both a decline in the ratio's numerator, profits, and a rise in its denominator, equity levels held. And there is a causal relationship between the two.
For starters, analysts say the industry overall may have to settle for fewer profits, precisely because bankers will be forced to hold more common equity on their books to satisfy regulatory requirements and to assuage investors' worries. Profits may also be diminished as institutions bear increased regulatory costs such as higher deposit insurance premiums.
Finally, the credit crisis has forced many bankers to focus on bread-and-butter lending and other less exotic — read less lucrative — business lines.
"Risk and return go hand in hand," said Scott Siefers, an analyst at Sandler O'Neill & Partners LLP, who expects lower returns in the foreseeable future as the industry readjusts its risk appetite toward plain vanilla.
"Perhaps that's good news for the soundness of the system but perhaps not as good news for investors — at least for those hoping for the kind of profitability that we've become accustomed to over the last decade or so," Siefers said.
James Bradshaw, an analyst at Bridge City Capital LLC in Portland, Ore., said the main driver behind the lowered benchmarks is the increase in common equity.
As regulators and investors continue to home in on tangible common equity ratios, more bankers will be pressured to raise additional common equity and rely less on debt instruments, trust-preferred securities, subdebt and preferred issues, Bradshaw said.
Those that are raising common equity to exit the Treasury Department's Troubled Asset Relief Program will also see their return on equity drop, he said.
One example would be U.S. Bancorp. Analysts said its return on equity, which was 9% at March 31, will likely be lower for this quarter. The government concluded in its stress tests results that the $264 billion-asset Minneapolis company did not need to raise additional capital, but this month it netted $2.4 billion in a common stock offering to help repay the $6.6 billion of government capital it received last fall.
Analysts are divided on when bankers will be able to sustain double-digit returns again.
Some say large, historically better-performing companies such as JPMorgan Chase & Co., Wells Fargo & Co., U.S. Bancorp and PNC Financial Services Group Inc. will achieve this goal as early as next year. All of them except JPMorgan Chase had ratios of 9% or above in the first quarter, but their ratios are likely to drop in the coming quarters, because the companies have announced effort to raise capital this month. (JPMorgan Chase's return was 5% as of March 31.)
"The cream of the crop will get there next year, and the banks that get their loan-loss provisions down the fastest will be the first," Bradshaw said.
Other analysts contend that credit quality will not improve significantly until at least 2011, so neither will profitability ratios for most banking companies.
"It will be a long process to clean up the distressed loans, and even for those that are 100% performing, if anything goes sour and the underlying collateral value has evaporated, banks will have to recognize losses," said James Abbott, an analyst at Friedman Billings.
Bankers on average will likely not post returns much above 7% or 8% over the next 18 months to two years, Abbott said, though it should be noted that some companies around the country continue to post ratios well above 15%.
In fact, supercommunity banking companies — those with around $10 billion to $30 billion of assets — have generally fared better than others, he said. Such companies have diversified into more business lines than smaller companies, but they generally did not get bitten by massive writedowns in the capital markets, as many larger companies did. Therefore, the supercommunity group generally has had fewer capital issues than others, and for the most part its members have been able to generate more stable profits, he said.
None of the banking companies named in this story would discuss the issue.
Not all analysts say the banking industry is entering an era of lower profitability. Anthony Polini, an analyst with Raymond James & Associates, said that in the previous cycle, a lot of the profits went off the balance sheet and into investment banks and conduits. However, the credit crisis has dried those markets up.
"There's a very strong argument that banks will benefit much more from balance sheet growth this time than they have in the previous cycle," Polini said. "I actually think profitability will be higher than before."
Some also cautioned that return on equity will not be the lone measure. Siefers said investors are also likely to take into account return on assets, because return on equity may become clouded with uncertainty around the appropriate level of common equity to hold on the books. (Analysts said the return on assets had almost been considered irrelevant in recent times.)
The industry benchmark for return on assets was around 1.5% before the credit crisis, but Siefers expects bankers to set as their goal anything above 1%. As of March 31 only one of the top 10 banking companies had a ratio above1% — State Street Corp., with 1.3%.