The Quiet Crisis in Banks' Shareholder Value
The market correction and likely longer timeline for a Fed rate rise have sent some overly optimistic investors to the door, and now prices are closer in line with the fundamentals. That's setting the stage for a bounceback in some of the biggest banks' stocks and may ease pressure on them coming into third-quarter earnings season.
When it comes to bank performance, appearances can be deceiving. Earnings throughout the industry continued to improve in the second quarter of 2015. But banks' ability to create strong shareholder value in the post-crisis era remains in doubt.
That's because a bank's value depends not on earnings but on its excess returns. This measurement allows shareholders to compare an institution's performance to similar investments with the same level of risk. It is calculated by determining the difference between a bank's return on equity and its cost of equity.
The current cost of equity in the market is in the 8%-10% range for most banks using the dividend discount model, according to the estimates of most industry experts. This is about 2% lower than pre-crisis estimates. The decrease in cost of equity is attributable to lower interest rates and reduced levels of risk.
Bank ROE has recovered from crisis lows thanks to improvements in asset quality and banks' cost-cutting measures. However, ROE has stagnated in the 9% range since 2013 — significantly down from pre-crisis levels, which hovered in the mid-teens. The industry's slide in ROE more than offsets the decrease in cost of equity.
The decline is reflected in lower market-to-book valuation multiples, which compare shareholder investment in a bank to the value created on their investments via economic profits.This multiple has fallen across the industry from two times book value during the pre-crisis era to 1.3 times book value, based on SNL Financial data. This suggests that banks' ability to create value on shareholder investments has fallen since the crisis.
Some have been quick to blame regulatory changes, especially the Dodd-Frank Act, for banks' performance problem. However, these changes have merely exposed the structural problems that were once hidden by the industry's unsustainable, high-risk business models based on over-leveraging, excessive concentrations in real estate and trading. True, banks' equity levels have increased since 2007. But the ROE issue lies largely with earnings.
Net interest margins have been declining for years in varied regulatory and interest-rate environments. These declines have been driven by intense competition in a market suffering from over-capacity. Furthermore, efficiency ratios are stubbornly high at near 60%, which shows that banks have not made cuts to their expense bases that match the declines in net interest margin. Finally, asset growth has fallen from 7-8% in the pre-crisis era to the current 3-4% level, according to data from the Federal Deposit Insurance Corp.
Banks have responded to these developments largely with incremental cost-cutting while leaving their expensive, branch-based models intact. This is because banks, unlike investors, regard their performance troubles as a cyclical issue rather than a structural one. Consequently, they have largely hung onto their origination staffs and branch facilities rather than focusing on new revenue opportunities.
There are exceptions to the rule. Wells Fargo, for example, has found a sustainable business model based on scale and the strong performance of its mortgage, auto lending and credit card divisions. The bank's success is reflected in its superior ROE and valuation multiples. Most institutions, however, are struggling to find the right approach.
Going forward, expect to see wider performance variations among banks as they experiment with new ways to improve results — not all of which will be successful. Shareholder activism will increase accordingly, especially since bank stock prices have softened in the current stock market correction.
The current industry consolidation rate of 4% per year means that one in five bank CEOs can expect to have their tenure cut short over the next five years, whether the cause is a merger or termination for a bank's lagging performance. Competition from fintech companies could hasten the consolidation process. In this environment, banks need to prove that they are earning enough to justify their continued existence.
While the banking industry structure is challenging, it still offers opportunities for smart financial institutions. The issues banks face with ROE lie in their aging business models. Too many banks are afraid to break the mold and instead do business in much the same way they did before the crisis. This is unlikely to lead to better results. To fix the problem, banks have to embrace change.
J.V. Rizzi is a banking industry consultant and investor.