The recovery in bank share prices since their March lows suggests the worst may be over for the industry. Most of the current bank stock rally, however, reflects the elimination of the former depression-scenario discount, not improving fundamentals.
Nonetheless, investors have shifted their valuation focus from tangible book values to core earnings. The shift may, however, be premature given unresolved holdings of toxic assets. That means investors may be unprepared for the potential re-emergence of adverse credit events. Banks must demonstrate sufficient earnings power to cover toxic-asset losses to satisfy investor concerns. Weak loan growth, depressed returns on equity and an uncertain regulatory environment will complicate that effort.
The high-risk, high-growth bank spread model effectively failed during the summer of 2007. The banking system was and is kept afloat only through extraordinary government efforts. The spread model at its core is a risky, borrow-short/lend-long arbitrage strategy. The current steep yield curve benefits banks. Banks cannot rely on such conditions as a long-term strategy. Sooner rather than later, excess capacity and competition will once again pressure margins.
Traditionally, this triggers an increase in risk profiles as banks resume growth strategies. We have already seen this increase at some of the "too big to fail" group of 19 banks. Ultimately this pressure will spread to regional and community banks. Unfortunately, this is not a sustainable strategy from either a regulatory or shareholder perspective. This is reflected in the price-to-earnings trading multiples for banks. Investors in effect are viewing banks as regulated utilities.
Banking is a cyclical mature industry, and needs to be managed as such. Market share growth in mature industries is a zero-sum game, which comes at the expense of other participants. Thus, rapid-growth strategies are likely to be costly, especially when based on high-risk lending.
Many bankers, however, find this difficult to accept, and continue to believe rapid growth is an imperative. This is partly driven by compensation arrangements tied to increased earnings and size. These arrangements make nominal growth secured by increasing risk levels irresistible. Frequently, as demonstrated by current banking problems, these risks do not pay back. Managers should not presume a growth strategy is best for their firm as economies of scale and scope are quickly offset by inefficiencies and complexity. Linking credit growth with value creation is no longer a reliable strategy. Growth adds value only when the spread between return on equity and the cost of equity is positive. Increasingly, the cost of equity is rising faster than return on equity. Under these circumstances, growth actually destroys value.
Competing in a mature industry with diminished growth prospects and low valuations multiples requires focusing on maximizing the performance of existing assets rather than chasing market share or growth. There are six steps to operating in this environment.
First, the focus should be on leadership positions in a few critical areas where you command a competitive advantage. This may require repositioning the business model through the divestment of noncore units, while engaging in acquisitions to support and enhance core operations. One example would be a shift from product- and distribution-based structures to relationship-driven organizations.
Second, capital allocations must be scaled back to match opportunities rather than trying to create opportunities to match management's ambitions. This requires discipline to avoid funding noncore growth and acquisitions.
Next, governance and incentive programs must be revamped to remove the existing capital intensive growth and risk-taking bias. Instead, they should encourage managing for risk-adjusted return with an enhanced emphasis on risk management.
Fourth, attention to dividend policy is needed. Dividends become an increasingly important component of shareholder returns in mature industries.
Next, enhance financial flexibility by rebuilding over leveraged holding company capital structures. This includes replacing borrowed equity instruments like trust-preferred and holding company debt with real common equity.
Finally, the program needs to be communicated to shareholders to ensure the banks are valued properly. Additionally, other stakeholders, including regulators and rating agencies, should be informed.
The market crisis will accelerate industry consolidation. The highly competitive transition state requires improved efficiency to offset margin pressure. This involves reconfiguring value chains and distribution channels. Returns on equity, not high-risk assets and earnings growth, are the key to higher valuations in the postcrisis environment. Executives accepting this fact will find they can truly get more value from less growth.
