Bank stock investors should know that the industry's sparkling returns on equity these days probably reflect higher but hidden risks, according to one Wall Street analyst.
Risks are being assumed, perhaps unknowingly, because low inflation has pulled a once-comfortable cushion from financial results and dictated greater exposure as a means of bolstering returns, according to Diane L. Merdian of NationsBanc Montgomery Securities.
The current "real"-that is, inflation-adjusted-return on equity for the banking industry of around 14% is roughly three times the levels of the last three decades, she said in a recent report.
"Indeed, current real ROEs for banks are higher than in any period going back to the 1930s," the analyst said.
The easy answer is that banks are operating in a golden age of higher efficiency with advanced technology and minimal loan losses. Moreover, bank managerial compensation is often tied to returns on equity, creating a powerful stimulus to serve shareholder interests.
But Ms. Merdian is skeptical that banks "are three times as productive as they were previously." Among other things, bank efficiency ratios were better during the 1950s, she said.
Instead, she suspects that some portion of current bank ROEs are being derived from higher risks, probably in lending, capital markets activities, and acquisitions.
It could be happening because few in banking have paused to ponder the profound implications of low inflation.
"Achieving even the same nominal returns as 10 years ago means a bank must reach a much higher real return on equity," the analyst said. That means shouldering more risk.
"Hitting ROE targets in the mid-teens was probably significantly easier in the 1970s (when inflation of 7% to 10% was built into returns) than it is today," she commented, "despite any advances in technology or reduction in excess industry capacity since that time."
The increased risks being taken to raise returns in an era of low inflation are not obvious. Instead, they are beyond the balance sheet, Ms. Merdian said, probably in three main areas.
Capital markets. Banks' derivatives activity has soared in the 1990s. Risk-based capital requirements may have encouraged risk-shifting from loans to the securities market.
Acquisitions. Operational risk from bank mergers is "significant and likely underestimated." Risks are hard to assess and banks accounting for deals under the pooling method can "understate their investment and boost reported returns on equity."
Loans. Recent bank lending has gone disproportionately to the more highly leveraged financial sector-mortgage companies, specialty finance companies, and brokerages. u