Goldman-led charge on returns maths falls short

October 20, 2016

By Dominic Elliott and Antony Currie

The authors are Reuters Breakingviews columnist. The opinions expressed are their own. 

A Goldman Sachs-led fight on bank returns will be hard to win. Chief Executive Lloyd Blankfein considers it “a little bit odd” the industry’s cost of equity is widely regarded as about 10 percent. The European Central Bank reckons it fell last year. Shareholders are better off playing it safe.

The debate has escalated because returns are anemic. Few U.S. banks managed to reach the de facto 10 percent hurdle in the third quarter. In Europe, Commerzbank just lowered its own return target to a mere 6 percent – and on a more generous interpretation of equity, too.

Embracing a lower cost of equity would boost share prices. Banks typically trade at one times book value when they achieve a 10 percent return on equity. Recalibrating the cost hurdle to, say, 8 percent would help laggards and standouts alike.

The cost of equity is hard to calculate with precision, however. Two common methods – the dividend capitalisation and capital asset pricing models (CAPM) – each have flaws. Several European banks, for example, have frozen shareholder payouts. Meanwhile, the three inputs for CAPM – government bond yields, wider stock market returns and relative volatility – aren’t static and are thus open to interpretation.

Even so, much has changed that supports reconsidering the cost of equity. Interest rates have been ultra-low for years. Regulators also have imposed higher cushions in case of crisis. And most large financial institutions have slashed risky assets.

The Bank of England has noted that this should make lenders duller and safer, and so bring down the cost of equity. Similarly, Ignazio Angeloni, an ECB supervisory board member, recently pegged the 2015 level at just above 7 percent. With preferred stock for the likes of Goldman yielding about 6 percent, it doesn’t sound a stretch.

At the same time, ECB analysis suggests it rebounded above 10 percent this year, and another of the central bank’s officials reckons 9 percent was a fairer estimate for 2015. Shareholders cannot reasonably modify valuation assumptions to accommodate such swings.

Longer-term trends favor a conservative approach. U.S. interest rates may be rising. Dividend payouts for European banks could be yet more constrained now U.S. stress tests also target them. The potential for tougher capital rules taking another toll on earnings clouds the outlook. In theory, how to judge the acceptable return threshold is a discussion worth having. In practice, investors would do well to stick with 10 percent.

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