Earnings and share prices are up at major banks, but the industry is not out of the woods yet — by a long shot.
The issues facing banks today are more about fundamentals than cyclical factors. Banks are clearly benefiting as recovery takes hold; it is changes to the regulatory environment, such as increased capital and liquidity requirements and debated regulatory reforms, not to mention a global bank levy, that will keep pressure on industry economics.
Some analysts estimate that proposed regulatory changes could cost banks up to 8 percentage points in returns versus historical levels, rendering most banks economically unprofitable.
To ensure profitability, banks will have to do more than simply ride the yield curve. Reconciling the need to deliver real benefits to customers and returns to shareholders while satisfying regulators is no easy task.
Banks must go back to the basic discipline of value creation. This will require much greater attention to returns — a break from the recent overemphasis on growth. Banks need to be more selective in taking on risk and more disciplined about understanding where and how they add value. They need to rapidly redirect capital toward the highest-value opportunities, be prepared to "fire" unprofitable customers and sell assets to release trapped capital.
They also need to be sharper not only about measuring and managing different types of risk to intrinsic value, some of which are not well understood today (liquidity, value of future business, systemic risks), but also about realigning pricing and costs with the delivery of benefits that customers are willing to pay for.
It sounds simple, but becoming "simply better" is no small task: it will distinguish the winners from the losers.
If management is not up to the challenge, the banking system as we know it today will not be sustainable.
Although absolute performance is improving, major U.S. banks are not earning their cost of equity capital — the return that shareholders expect for taking on investment risk.
For example, JPMorgan Chase, considered a winner coming out of the crisis, earned only 8% return on equity in the first quarter. Bank of America's return on equity was similar, at 7%, and Wells Fargo's was 9%.
In 2010-2011, 22 out of 27 major banks — those with assets of more than $25 billion — are expected to fail to earn an economic return — a staggering 90% of the sector's capital.
There are a few exceptions: American Express, U.S. Bancorp, Goldman Sachs, Northern Trust and New York Community. But even these companies are expected to earn returns well below historical averages.
The industry's market value-to-book value ratio of 1 — the lowest level over the last two decades — is a clear signal that the sector's economic profitability will remain low for the foreseeable future.
While banks alone cannot build a sustainable banking system, management's own discipline and standards for decision-making and execution will play a major role in restoring the health of individual banks.
