If 2008 was a heart attack for the world’s banks, 2020 is showing the sector to be both morbidly obese and dangerously addicted to prescription drugs.
A repeat of the banking sector coronary of 12 years ago, which the global economic shutdown amid Covid-19 might well have triggered, appears to have been averted.
But the central bank interventions that have held down capital costs and helped mitigate customer loan losses — via ramped-up quantitative easing and a further lowering of perennially ultralow interest rates — have had a nasty side effect. Combined with the build-up of plump capital buffers that policymakers have insisted on over the past decade, they have conspired to destroy returns, rendering many banks essentially uninvestable.
Sure enough, bank shareholders have deserted the sector in droves. Despite the vanishing risk of banks having to launch dilutive emergency capital raisings, or experiencing more existential problems, share prices have plunged by a third in both the US and Europe so far this year.
The price-to-book ratio of JPMorgan Chase’s net assets. The ratio for the biggest European banks is less than 0.5
Short-term loan losses aside, investors have two related concerns. The first is that profitability has been permanently impaired by monetary policy. Echoing longtime pressures for Japanese lenders, and a “Japanification” of eurozone interest rates, European bank margins have shrunk painfully in recent years. According to Citigroup, the average European bank will make a return on tangible equity of barely 2 per cent this year and 5 per cent next, compared with more than 20 per cent in the run-up to 2008. Even in the US, ROTE projections for 2020-21 average only 10 per cent. And there will be no let-up. The Federal Reserve last week cemented expectations that the US central bank will keep interest rates at ultra-low levels for the long term when it revealed a new monetary policy strategy that will allow for temporary spikes in inflation without rate rises.
Investors’ second worry is that distributable returns to shareholders, via dividends or share buybacks, will be doubly constrained — not only by structurally lower profitability, but also by regulatory blocks on payouts. So extreme has the protection of banks’ balance sheets been that the near-record loan loss provisions taken by many lenders in the first half of the year have still not dented vast surplus capital levels. According to the FDIC, one of the US regulators, US banks in aggregate now have excess capital beyond regulatory minimums of $1.2tn. In the eurozone the figure is €480bn, according to the European Central Bank.
For 2020, regulators have eased demands on capital, allowing a portion of the buffers to be used to absorb losses. But there has also been a wisely cautious stance to restrain payouts to shareholders — reflecting uncertainty over prospective bad debts and a keenness that banks should maintain their capacity to lend. In July, the ECB extended previous guidance, asking banks not to pay dividends or buy back shares until 2021.
Value of BNP Paribas, the best in the eurozone
From January, though, European banks are already pinning their hopes on being released from this constraint and winning back investors with the prospect of windfall payouts.
US banks have a lot more going for them. Generally healthier balance sheets and a more profitable home market means they are fundamentally more appealing. Even after this year’s decline, America’s biggest bank, JPMorgan Chase, is valued at more than $300bn. The best Europe can muster is HSBC, worth £67bn ($88bn), or in the eurozone BNP Paribas (€46bn/$54bn). JP’s valuation is the equivalent of 1.3 times the book value of its net assets. The price-to-book ratio for the biggest European banks is less than 0.5.
Europe’s lenders have struggled for a decade to find a fix. Costs have been cut, though with minimal benefit for the bottom line. Merger deals to help accelerate cost-cutting have proved largely elusive. Efforts to spur change by activists, such as Cerberus’s equity stakes in multiple German banks, have yielded little more than vast investment losses.
The fall in European banks’ valuations, even as capital buffers have remained ample, has led to a balance sheet oddity for some. Italy’s UniCredit, for example, now has surplus capital that exceeds its market value. In theory at least, such banks could de facto be bought for free — even by themselves. In reality, that kind of operation would be fraught and impractical, but after heart attacks, obesity and addiction, this distortion is further proof of the serious underlying health condition of Europe’s banks.