From an earnings perspective, banking in the 21st century has been a tale of two wildly different periods.
As reflected in this Bloomberg chart, the first period from 2000 to 2007 was a time when banks often experienced rapid growth and lofty stock price multiples — frequently outperforming the broader Standard & Poor's 500 index. How such a competitive industry could achieve these returns was puzzling then. Now it is clear that the performance was largely an illusion based on difficult-to-evaluate risk-taking. Regulators and the market failed to recognize this until the crisis materialized, thereby damaging investor trust in banking.
The post-crisis period, beginning in 2008, marked the second part of this story. Since then, the banking industry has largely failed to earn its cost of equity, estimated at around 10% since the financial crisis, despite the flood of liquidity in the market. Today, banks’ lagging stock price performance suggests that attempts to try to jump-start growth — and external factors thought to be beneficial, such as deregulation — have not had their desired effect, and may not for the foreseeable future.
Indeed, the financial services index is still off its pre-crisis 2007 highs despite the post-election “Trump bump” and a benign economic environment. This is in contrast with the S&P 500, which has exceeded its pre-crisis high. It is convenient to blame the lackluster banking results on regulation — especially the Dodd-Frank Act. But blaming a law — or anything else — is not a strategy.
Hopes that the Trump bump would continue have not been realized. Investors are betting that deregulation and tax cuts, if they ever materialize, will largely benefit consumers, not banks. Real interest rates set by investors in the capital markets have failed to rise despite predictions that they would, reflecting sluggish long-term growth in the prolonged economic recovery. Net interest margins and return on assets have continued their long-term decline.
With banks fighting a perception of mediocrity, some analysts have suggested that banks need to pull out more stops to recapture pre-crisis growth and pricing multiples. With the excess of cash and the trend toward lighter regulation, these analysts view short-term steps to try to increase shareholder value — such as higher dividends — as a management failure. They belittle banks’ post-crisis business models as “utilitylike.”
But just as pre-crisis earnings were illusory, so too might be the expectations that banks can ever regain their pre-crisis earnings glory. “Dare to be great again” growth calls should make banks beware. The negative fallout of the pre-crisis bank growth speaks for itself.
Sustainable, profitable growth is determined by the realistic assessment of your competitive position, not the ambitious expectations of overconfident management and analysts. In fact, bank investor returns are, frequently, inversely related to managerial ambitions.
Viewed in this light, steps such as increased shareholder distributions represent good shareholder stewardship, not failure.
Investors likely won’t respond well to banks that are hoping conditions return to pre-crisis levels. What if this is as good as it gets? Investors are skeptical about opaque bank growth strategies that are based on overpriced acquisitions and undifferentiated organic growth in mature markets. Instead, investors are focusing on banks as yield investments that are based on shareholder distributions, including both dividends and repurchases. Dividend increases, not asset growth, will drive future bank stock prices.
Resisting these realities will destroy shareholder value and lead to continued investor mistrust.