The financials have been leading this recent stock market rally, which is a very healthy sign. They were certainly beaten up, for good reason, during the financial crisis. Since banks were at the center of the crisis, it is probably a good time to examine the issues particular to them to see where they are today.
Banks traditionally made their money by "spread lending," which is taking money in on deposit and then lending it out at a higher rate to cover costs and risks, leaving a margin for reasonable profits. As we now know, the large global banks increased their leverage (assumed more liabilities, including deposits, in comparison to their capital), set up off balance sheet vehicles, underwrote securities and derivatives, and engaged in proprietary trading. These activities enhanced the profitability of the banks. However, neither the bankers nor the regulators fully understood the risks, which became all too apparent in a severe credit crisis. Well functioning banks are essential to a healthy financial system. Bank failures, which unfortunately happen from time to time, should not prejudice the entire system. However, when banks become "too big to fail" because their failure would jeopardize the national, or even the international, financial system, legislators and regulators refocus their efforts to reduce risk, particularly among the largest banks. We calculate that the five largest US banks have about 44% of all American deposits, up from 28% 10 years ago.
The Basel III international agreement dating from last September requires the large banks to increase Tier 1 capital (common equity plus retained earnings/ total assets) from 2% to 7% by 2019. Most American, Canadian and Japanese banks meet the new requirements. American and British regulators are insisting on additional capital. European banks, which have huge loans outstanding to now questionable sovereign credits, are struggling to find the right formula for increasing capital. Sovereign loans were previously considered risk free and did not require a capital allocation. Of course, issuing new capital reduces profitability by diluting current shareholders. The Dodd-Frank Bill is imposing other limits on risk taking, which may likely reduce income.
Banks are restructuring to better cope in the new global environment and paying fines for past sins. Last year, UBS and Citigroup announced over 20,000 in job cuts. Barclays and Credit Suisse may significantly reduce the size of their investment banking staffs. Standard Charter is facing $667 million penalty for violating sanctions against Iran and Libya. HSBC settled for $1.9 billion for money laundering in Mexico. Banks caught up in the LIBOR interest rate rigging scandal will be facing significant costs, as yet undetermined. Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo have paid $61 billion to settle mortgage claims over the past three years. It is likely that there will be other costs before this is over.
As the banks raise capital and unwind excesses from prior years, we have seen their stock prices increase in value. As government authorities continue to restrict bank activities and penalize them, earnings may not return to the highs of prior years when they were considered growth stocks. If anything, they may be more like regulated utilities. Investors seem reassured that problems are being addressed and risks are abating. In fact, more banks are requesting their regulators to increase dividend payouts. Banks seem to be gaining the attention of investors looking for stable and potentially growing income.
John Hess Managing Principal (203) 655-4700 jhess@nsinvestors.com www.nsinvestors.com | Falgun Jariwala |
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1. Gary Shilling'sInsightMarch 2013