August was a difficult month for bank stocks. The KBW bank index fell at one time during the month by over 20% before recovering to a month-end 13.4% decline. This pattern has been consistent for bank stocks, which have retreated from their April highs due to the return of macroeconomic concerns. The KBW index is down 23.1% while the broader S&P 500 is only off 3.7%, year-to-date.
This development gives rise to two questions. First, is the decline rational or does it represent an irrational overreaction to recent events?
Next, how should bankers respond? The response depends on your answer to the first question. If the decline represents a rational repricing based on changing earnings prospects, then you should consider changing your business model. If irrational, then you may wish to ignore the decline.
What happened?
Investor concern increased this summer given the U.S. ratings downgrade, GNP revision, worsening euro, and the recently announced Fed interest rate freeze policy. Additionally, regulatory changes have increased costs. Thus, analysts have recently cut near term banking earnings estimates by 30-40%. Smaller institutions were especially affected given their dependence on spread income and the decline in their deposit franchise value.
Investors are reflecting a justifiable concern on whether banks can earn enough to cover their cost of equity in a difficult low-growth macro environment. This is based upon the possible return of deflation risk. Banks, as we learned from Japan, suffer in a deflation as both loan demand and rates fall.
Investors are distinguishing short-term credit recovery related income gains from Pretax Pre Provision (PTPP is an operating earnings measure) improvements. The lack of PTPP improvement is reflected in falling price to book value and price to earnings multiples.
Investors focus on expected ROE and cost of equity when setting book value multiples. The book value relationship is set by ROE divided by cost of equity. Alternatively, P/E ratios can be obtained by simply dividing book value by ROE. Banks create franchise value when expected ROE exceed their cost of equity resulting in book value multiples above one.
Currently, bank capital costs, according to published sources, are around 10%. Industry ROE through the second quarter averaged around 7.5% to 8%. Consequently, many banks are now trading at book value multiples below one. ROEs should normalize at 10% assuming returns on assets reach 85-100 basis points with equity levels of 10%. Thus, average book value multiples of near one are expected.
This is a far cry from pre crisis book multiples of two or more which reflected ROEs in the mid-to-high teens based on higher asset returns and lower equity levels.
Managers are frustrated at current value ranges. Predictably, they believe their banks are undervalued, based on their view of projected returns. Alternatively, investors are expressing concern with their current strategy.
In fact, the current situation really reflects a crisis of strategy. Most banks have not addressed their fundamental cost-structure imbalance. They are blocked by "me-too" best practices herding into trying to do better with others already doing well. This includes growing core deposits and increasing commercial and industrial loans.
They are nibbling around the edges of the problem while hoping to ride out the storm utilizing the same pre-crisis business model. These banks appear fairly priced at current low multiples given their existing strategy. Institutions seeking to improve their multiples need to raise ROE from the current low levels to the mid-teens. Each 2% increase in ROE under the prior assumptions improves the market-to-book ratio by 0.25. This, however, requires a change in thinking and business models.
The industry suffers from denial. Banks are unable to appreciate the implications of market changes on their business model. The end of the great 25-year moderation and the return of volatility means business model sustainability will be measured in dog years. The cost structure established to support the prior asset origination based real estate business model is obsolete. It is unrelated to the available level of revenue opportunities.
The usual refrain is banks cannot cut their way to prosperity. Equally true, however, is no bank can be prosperous if it is inefficient. The cuts must be part of an overall strategy which could include, for example, consolidating acquisitions.
Banks must move beyond the past and focus on how markets have changed and how to adapt. Strategy is context dependent and shaped by the industry's changing environment. Weak PTPP requires substantial expense cuts to produce an adequate return. In the current environment, returns trumps growth. Consequently, banks need to drive ROA through their efficiency ratios. Banks unable to adopt will be forced to sell. Even if the macro headwinds moderate, bank stocks are likely to lag other sectors based on existing industry structural, as opposed to cyclical changes.
Bank stock declines reflect a valuation, not a Lehman type liquidity crisis. The industry raised hundreds of billions of new capital since 2008. This is, however, a double-edged sword as they failed to generate the higher earnings required to support the new capital. Bankers must ensure their business model is robust enough to withstand profitability challenges. If not, difficult business model changes may be required.
Survival is not mandatory. Those seeking to survive, however, should heed the signals from dissatisfied investors. The problem is not with your stock price or irrational investors, but with your strategy. You ignore the warnings from your investors at your peril. The future has already happened, and the status quo is no longer an option. Either you chose strategies more appropriate for the current market environment, or someone else will.
Joseph V. Rizzi is a senior strategist at CapGen Financial Group, a private-equity firm. He spent 24 years at ABN Amro Group and LaSalle Bank.
