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The market correction and likely longer timeline for a Fed rate rise have sent some overly optimistic investors to the door, and now prices are closer in line with the fundamentals. That's setting the stage for a bounceback in some of the biggest banks' stocks and may ease pressure on them coming into third-quarter earnings season.
August 28 -
First Financial Northwest is moving past its thrift roots three years after a proxy battle ousted its chief executive. Other banks in the same position are still trying to get back on track.
August 27 -
Even if stock losses cause the Fed to delay tightening, it won't be a catastrophe for banks' future earnings, according to a study of analysts' forecasts. Margins were not expected to balloon even if the Fed did act.
August 26 -
Stock fluctuations will fuel investment banking fees in the short run, but a prolonged shock would complicate bank M&A and could tighten margins, crimp wealth management fees and present other risks.
August 24
When it comes to bank performance, appearances can be deceiving.
That's because a bank's value depends not on earnings but on its excess returns. This measurement allows shareholders to compare an institution's performance to similar investments with the same level of risk. It is calculated by determining the difference between a bank's return on equity and its cost of equity.
The current cost of equity in the market is in the 8%-10%
Bank ROE has recovered from crisis lows thanks to improvements in asset quality and banks' cost-cutting measures. However, ROE has
The decline is reflected in lower market-to-book valuation multiples, which compare shareholder investment in a bank to the value created on their investments via economic profits.This multiple has fallen across the industry from two times book value during the pre-crisis era to 1.3 times book value, based on SNL Financial data. This suggests that banks' ability to create value on shareholder investments has fallen since the crisis.
Some have been quick to blame regulatory changes, especially the Dodd-Frank Act, for banks' performance problem. However, these changes have merely exposed the structural problems that were once hidden by the industry's unsustainable, high-risk business models based on over-leveraging, excessive concentrations in real estate and trading. True, banks' equity levels have
Net interest margins have been
Banks have responded to these developments largely with incremental cost-cutting while leaving their expensive, branch-based models intact. This is because banks, unlike investors, regard their performance troubles as a cyclical issue rather than a structural one. Consequently, they have largely hung onto their origination staffs and branch facilities rather than focusing on new revenue opportunities.
There are exceptions to the rule. Wells Fargo, for example, has found a sustainable business model based on scale and the strong performance of its mortgage, auto lending and credit card divisions. The bank's success is reflected in its superior ROE and valuation multiples. Most institutions, however, are struggling to find the right approach.
Going forward, expect to see wider performance variations among banks as they experiment with new ways to improve results — not all of which will be successful. Shareholder activism will increase accordingly, especially since bank stock prices have softened in the current stock market correction.
The current industry consolidation
While the banking industry structure is challenging, it still offers opportunities for smart financial institutions. The issues banks face with ROE lie in their aging business models. Too many banks are afraid to break the mold and instead do business in much the same way they did before the crisis. This is unlikely to lead to better results. To fix the problem, banks have to embrace change.
J.V. Rizzi is a banking industry consultant and investor.