Risk and return in the banking sector
By Nick Forrest and Miles Kennedy
The risk of investing in the banking sector does not appear to be subsiding. Bank share prices remain exceptionally volatile and ongoing regulatory developments continue to weigh on the sector. One important measure of risk is the “beta” for a bank. This combines the volatility of bank shares and their correlation with the equity markets in general. It is a key risk measure because it helps to set banks’ cost of capital and therefore the appropriate level of returns they should be targeting. The higher the beta, the higher the cost of equity and as shown in the chart below, bank betas are currently significantly above 1 – the average across the market.
[Click to view a larger version]
This may be surprising. Given the substantial recapitalisation of the banks across the world and the implementation of a raft of regulatory reforms, we may have expected risk levels across the sector to begin to fall by now. However, offsetting impacts including the fallout from the Eurozone crisis (which impacts banks directly through holdings of Government bonds) and continued sector uncertainties have contributed to this continued elevated state. We must remember that the equity beta, by its calculation, is a lagging indicator of risk so it will take time for risk reductions to show in the empirical data, but the key questions remains of whether and by how much risk will reduce in the banking sector.
The future track of risk in the banking sector is of critical importance to banks, their shareholders and policy makers. Some envisage a “back to basics” world of low risk/low return utility banking. Others suggest that credit risk, interest rate risk and liquidity risk mean such a world is impossible to achieve – the fortunes of the banking sector will always be entwined with the broader economy.
Where we end up is crucially dependent upon the effectiveness of the banking reforms underway and the impact of leverage on the cost of capital for banks. In theory as more equity is used to finance a bank, the risks to that equity are dissipated, so the cost of equity should fall. There are obstructions to the theory, such as taxes and government involvement in the banking sector (through implicit guarantees), but the Bank of England showed empirically that leveraging effects should reduce the cost of equity for banks in Optimal Bank Capital and other risk reduction measures should also have an impact as reforms are implemented.
For an answer on where we should end up, we commend a recent PwC report: “Banking industry reform: A new equilibrium”. The report envisages a post-crisis equilibrium in which bank equity costs fall from current figures of around 12% to a range between 8%-10% following reform-driven reductions in bank leverage and a gradual return to financial market normality. Capacity overhang, competitive pressures, subdued underlying economic growth and a substantial adjustment and compliance cost burden will continue to impact performance severely in the short term, and keep long run equity returns to no more than 1-2% over equity costs thereafter. This is starkly different to the pre-crisis norms, where bank investors became accustomed to returns in the high teens, and will therefore require adjustment by both bank executives and investors.
Such a new equilibrium need not be feared. Returning to a positive spread over the cost of capital should restore bank valuations – price to book ratios currently languish at levels of around 0.5 times. A target return on equity of 9-11% should be achievable with some, but not drastic, re-pricing of banking products and a re-opening of debt and equity markets to enable banks to resume business on economic terms. On a reduced cost of capital of 8-10%, investors should welcome such returns given the risk profile of the sector should become much lower. By putting up the money, they could help transform what is now a vicious circle (capital scarcity; credit scarcity; deleverage; deflation; asset impairment; capital scarcity … in a word, procyclicality) into a virtuous one. For their part, banks need to help make themselves investable again, not by promising unrealistic equity returns, or by straining to deliver them through overly aggressive business and cost rationalisations, but by setting out a credible and sustainable strategic agenda, being proactive with their disclosures, and avoiding making the headlines for the wrong reasons!
Otherwise, the challenge is one of timing. Eurozone risks are not likely to be resolved in the short-term and economic weakness will continue to hold back bank performance. This new equilibrium will take time to materialise, but it is important that the sector and its investors are making long-term strategic decisions based on the longer-term direction of the industry.
Nick Forrest | Telephone: +44 (0)207 804 5695
Miles Kennedy | Telephone: +44 (0)20 7212 4440