RPT-BREAKINGVIEWS-Bank investors’ risk gauge looks faulty

Reuters
Oct 09
RPT-BREAKINGVIEWS-Bank investors’ risk gauge looks faulty

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

By Liam Proud

LONDON, Oct 8 (Reuters Breakingviews) - Banks are boring now. At least, that’s what their investors appear to think. Thanks to regulations spurred by the 2008 financial crisis, they have to sock away heftier loss-absorbing capital cushions, while much of the riskiest lending has seemingly shifted off the balance sheets of giants like $870 billion JPMorgan JPM.N or $340 billion Bank of America BAC.N. This reputation for dullness is becoming an enviable asset: shareholders now value the biggest lenders as though they’re imperturbable stalwarts. Recent history suggests that’s a dangerous bet.

Investors demand returns commensurate with the risk they perceive to be taking on. This is reflected in a company’s cost of equity, the threshold at which the two factors balance. It’s a slippery concept, though, and can only be inferred from stock prices rather than directly observed. Still, a handy shortcut is to divide return on equity by the multiple of book value at which a firm trades. It works well for banks, which are commonly measured on those two metrics.

A lender generating a 10% return and whose shares trade in line with book value is, implicitly, priced at a 10% cost of equity – a level that investors and analysts often consider the default for banks. By contrast, if investors are only willing to pay half book value, all else equal, they’re effectively demanding a 20% return. It’s analogous to the way that dicey borrowers must pay higher effective interest rates to secure credit.

Over the past 15 years, the average implied cost of equity for American, Canadian and European banks has been 9.4%, 9.5% and 12.2%, respectively. That’s according to Breakingviews calculations using LSEG data for the 25 largest Western lenders by asset value. The numbers come from dividing expected return on tangible equity over the next 12 months, based on analysts’ estimates, by the multiple of tangible book value at which a firm trades.

A big share-price rally has brought those figures well below historical averages, to just 7.9% for the Americans, 7.8% for the Canadians, and 11% for the Europeans at the end of September. Individual stars stand out. Analysts reckon JPMorgan, for example, is on track for a 19% return in 2026, estimates gathered by Visible Alpha show. Divide that by its multiple of almost 2.9 times 2025 tangible book value, and the implied cost of equity is about 6.5%. Royal Bank of Canada’s RY.TO equivalent figure is 7%. Spain’s CaixaBank CABK.MC is at roughly 9%.

Admittedly, banks have enjoyed single-digit costs of equity before, like during the early stages of Covid-19 lockdowns and around 2017. But both cases were arguably oddball quirks of the moment. In 2020, investors could reasonably expect shutdown-related loan write-offs to be a passing malady, only temporarily squelching returns. In 2017, they could get excited at the prospect of soaring income as the Federal Reserve prepared to hike interest rates.

Neither of those caveats apply today. Rates are falling, not rising, and loan losses are relatively subdued. Instead, the implicit hurdle that shareholders have set for bank stocks seems to suggest a utility-like ability to keep pumping out the same level of returns even if the economy falters. In other words, investors’ risk gauge for the financial system reads “very low.”

There are several possible justifications. For one, the possibility of total catastrophe seems much lower now that major international banks have fortified their balance sheets. By last June, they boasted an overall common equity Tier 1 capital ratio – a measure of their loss-absorbing buffers – of 13.4%, according to the Bank for International Settlements. That's up from 7.1% in 2011. They also passed a key test by weathering the pandemic on both sides of the Atlantic.

Meanwhile, many of the past culprits for massive write-downs are now someone else’s problem. Proprietary trading is now the domain of Jane Street and hedge funds rather than megabanks. Private credit firms, like Ares Management ARES.N and BlackRock’s BLK.N HPS Investment Partners, have taken on a growing share of leveraged buyout financing. Finally, specialist real-estate lenders like Rocket Mortgage have come to dominate the business of originating home loans.

There’s also evidence that banks have raised the bar on the loans they still write. The percentage of U.S. commercial and industrial loans that are between 30 and 89 days past due was 0.8% on average between 1994 and 2007, according to numbers crunched by Oppenheimer analysts. That’s an early indicator of future bad debt. Over the past decade, the same number has dropped to 0.3%. For credit cards, that key risk metric fell from 2.3% back then to 1.2% since 2015. If losses are lower, then banks’ returns should be much steadier and more annuity-like – akin to a utility.

Yet over a decade of low rates following 2008 arguably played a bigger role in keeping delinquencies low. And chunky equity buffers won’t matter if spooked depositors start yanking their money en masse, draining crucial funding. Credit Suisse and Silicon Valley Bank, after all, were stuffed full of capital. Rumours spread quickly over social media, and customers can pull out their cash with a few swipes on a smartphone.

Traditional lenders are also deeply intertwined with many of the upstarts who have ostensibly taken over their riskier activities. Banks offer leverage to private credit funds and prop traders, for example. A crisis at Ares or Jane Street may not leave the old guard unscathed.

It’s rarely possible to foresee exactly what will cause the next crash. Look at SVB, sunk in part by supposedly risk-free U.S. government bonds and mortgage securities that lost value as rates rose. Banks may not be the swashbuckling risk-takers of old. But they still depend overwhelmingly on borrowed money – much of which, like customer deposits, can flee at will. Investors are taking a bold bet by assuming that things have changed for good.

Follow Liam Proud on Bluesky and LinkedIn.

U.S. and European banks vs. their indexes over five years https://www.reuters.com/graphics/BRV-BRV/dwvklwdbxpm/chart.png

Implied cost of equity over time for the 25 biggest Western banks https://www.reuters.com/graphics/BRV-BRV/mopadgkgjva/chart.png

(Editing by Jonathan Guilford; Production by Maya Nandhini)

((For previous columns by the author, Reuters customers can click on PROUD/liam.proud@thomsonreuters.com))

Disclaimer: Investing carries risk. This is not financial advice. The above content should not be regarded as an offer, recommendation, or solicitation on acquiring or disposing of any financial products, any associated discussions, comments, or posts by author or other users should not be considered as such either. It is solely for general information purpose only, which does not consider your own investment objectives, financial situations or needs. TTM assumes no responsibility or warranty for the accuracy and completeness of the information, investors should do their own research and may seek professional advice before investing.

Most Discussed

  1. 1
     
     
     
     
  2. 2
     
     
     
     
  3. 3
     
     
     
     
  4. 4
     
     
     
     
  5. 5
     
     
     
     
  6. 6
     
     
     
     
  7. 7
     
     
     
     
  8. 8
     
     
     
     
  9. 9
     
     
     
     
  10. 10