Meredith Whitney on How to Bring Investors Back to Bank Stocks
This year presents a great opportunity for bank CEOs. With most of the large macro issues behind them, companies and their leaders have a chance to differentiate themselves.
For large banks, that means demonstrating tangible return improvements from cost containment, effectively by getting smaller. For smaller banks that means demonstrating tangible return improvements from gaining scalable efficiencies, effectively by getting larger. What works for large banks will not work for small banks and vice versa.
For the past few years, the large banks, most of which are deemed systemically important financial institutions, have been all but banished from a practice they once dominated: acquisitions. "Too Big To Fail" has essentially meant that they have to operate "as is," shrink, and not even dare think about buying other banks. This has thrown a strange twist into M&A, as the "natural" buyers of banks are all but sidelined, leaving the smaller banks to take a leadership role in the market.
As uncomfortable as this situation may be for the larger institutions, it actually provides them an excellent opportunity: get better at executing with what they already have rather than getting bigger for the sake of getting bigger.
For many, this will be a near-term challenge. Not only have the big banks not been accustomed to going in reverse, only a handful of them are openly accepting that the current weak revenue environment may actually be here to stay.
Along those lines, a handful of banks have just begun to outline specific efficiency targets and put programs in place to drive profitability improvements. For others, plans are well underway and 2013 is poised to be a banner year. From investors' perspective, this will be a "show me" year for large bank CEOs.
This will also be the year for the smaller banks to step up to the M&A plate. Prices in excess of two times book value are going to be very few and far between, so prospective sellers should think about the quality of the partner in addition to the price tag. The reality that bank deals over the past three years were done at roughly half the multiple of deals prior to the crisis is unlikely to change given the Fed's commitment to a zero interest rate policy.
The fact that more and more deals are being done with both a stock and equity component should be viewed as good for sellers. They can both monetize their ownership in often illiquid investments and retain a carried interest in what I believe will be an enormous growth market for the newly created superregional banks of the next decade.
For nearly 20 years, the larger banks have outmuscled smaller banks in M&A and undercut them on price in loan originations. In the worst cases, during the mid-1990s, some smaller banks binged on commercial real estate loans and are only now beginning to recover from the hangover of credit losses. In the best cases, some smaller banks have focused internally on efficiencies and built dry powder and strong capital stockpiles.
One of the messages frequently lost on investors as well as operators of banks is that just as the regulators want the "Too Big to Fail" banks to shrink, they need the smaller banks to get larger. That is the only way to rebalance an industry that's been imbalanced for 15 years. It would be a gift to both large and small banks.
The reality is that although bank stocks had a great year in 2012, the KBW Bank Index is still more than 50% below its 2007 peak. Investors still underweight the sector. For the most part, they are tired of hearing more about legacy issues than plans to drive business-as-usual profitability.
That can change quickly if banks take a leadership role. Instead of being preoccupied with things that aren't working, focus intently on what is working. Legacy issues will persist – but so, too, will the need to adjust to the new operating environment and drive greater profitability. First quarter results are a great launching pad for a powerful 2013.
Meredith Whitney is the CEO of Meredith Whitney Advisory Group LLC.