Four factors to determine bank returns

January 5, 2010

larsen.jpgWhat is an acceptable return on equity (ROE) for a bank? That question is likely to dominate the debate among executives, investors and regulators in the coming year. After the spectacular losses of the crash, there is no doubt that banks’ future returns should be lower than the super-charged profits earned during the credit boom. But if ROEs fall too far, the consequences could be severe.

Returns are already on the way down: just look at Goldman Sachs. Between November 2007 and September 2009, the Wall Street bank’s tangible common equity swelled by 74 percent. In 2007, its best-ever year, Goldman earned a 38 percent return on that equity. This year the bank is expected to report the second-highest profit figure in its history. But its ROE is likely to be just half its level of two years ago.

Of course, there is no good reason why banks should consistently earn 20 percent-plus on their equity, particularly when interest rates are at zero. During the 1970s and the 1980s, when interest rates and inflation were much higher, the return on tangible equity for the British banking industry averaged 10 to 11 percent, according to Credit Suisse research. This only changed in the 1990s, when looser regulations permitted large banks to increase leverage and take on more risk.

As long as central banks keep interest rates down and pump liquidity into the markets, most banks will continue to earn healthy profits, as they did in 2009. In the longer run, however, returns will be largely determined by four factors: regulation, competition, funding costs and economic growth.

Regulators are still finalizing the details of new rules that will force banks to hold greater capital buffers and require them to keep larger reserves of liquid assets. However, these will make banks less profitable than in the past.

Reduced competition will partly compensate for more regulation. Weak banks have been nationalized or absorbed by larger rivals. Upstart competitors that relied on wholesale funding have disappeared. As a result, surviving banks can charge more for loans than during the boom.

But this effect should not be overstated. Banks do not have a monopoly on credit: many large companies have already turned to the bond markets for their financing needs. Meanwhile, competition is narrowing the wide bid-offer spreads and volatile markets that made trading bonds and currencies so lucrative for investment banks in the past year.

Funding costs have also increased. According to Moody’s, global banks have $7 trillion of debt that needs to be refinanced before the end of 2012. Replacing cheap liquidity supplied by or guaranteed by central banks will also be costly. And as long as interest rates remain low, it will be expensive to tap alternative sources of funding, such as retail deposits.

Banks will benefit if western economies continue to climb out of recession. This will limit losses on past loans, and may even allow banks to write up the value of toxic debts they still hold. But growth in many countries looks set to remain sluggish, and demand for new loans will be limited as companies and consumers continue to pay back debt.

All this adds up to significantly lower ROEs than banks were able to earn over the past decade. Of course, banks are not entirely powerless when it comes to controlling their returns: one obvious way to boost their return is to pay their employees less.

A safer banking industry should mean that banks have a lower cost of equity. Nevertheless, banks will probably have to generate double-digit returns to maintain the interest of investors. For example, Lloyds Banking Group recently issued a tier one bond with a 12 percent yield. This suggests that investors should demand the promise of a higher return to hold the British bank’s shares, which are unlikely to pay a dividend for several years.

A lower ROE for the banking industry is a sign that the industry is safer, and that its profits are more sustainable. However, regulators must be careful not to push too hard for lower profitability. If returns fall too far, private investors will retreat. Then governments will once again be called upon to fill the gap.


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Posted by voomies | Report as abusive

I always wonder what ‘return’ means in the du Pont World. Is this nominal or real ? Equity is tiered, so this must be quite a complex calculation. I am sure you preferred not to venture into PE ratios and free cashflows on purpose.

A question begs – are these returns relevant when shares are held by a handful ? A million on a billion is just another million.

Posted by Ghandiolfini | Report as abusive