Do capital market banks deserve more investor respect?
Banks make tangible progress
Despite dramatic improvements in capital levels, liquidity, and asset quality, large capital market banks (i.e., brokers and money centre banks) trade at half their pre-crisis levels on a price-to-tangible book basis. Are investors correctly evaluating the risk and reward or do they remain anchored in crisis-era thinking?
Preparing for the quarterly earnings season, I was recently reminded of just how far the large global banks have come in terms of safety and soundness.
To be sure, the US has led the charge, but Europe is doing its best to catch up and adapt as well.
Despite this, the global banks are broadly trading at approximately half their pre-crisis valuation levels on a price-to-tangible-book basis. In our view, this presents an opportunity.
Pre-crisis: Picking up quarters in front of a steamroller
Prior to 2008, I would argue that owning brokers and money centre banks left investors exposed to catastrophe risk.
Nine out of ten years, investors collected premiums in the form of healthy book value growth.
However, leverage, illiquid asset build-up, and flawed funding structures meant that investors were constantly at risk of dilution or permanent loss.
Despite this, these global banks traded between 1.5 times to 2.5 times (or more) tangible book value.
Fast forward: What a difference seven years make
We believe today’s investors in capital market banks are exposed to a more favourable return profile.
Why the change in view? Regulators, rating agencies, and politicians have forced significant change within systemic banks. Key aspects of this change include:
- More capital: Banks are holding a lot more capital. On a simple capital-to-assets view, equity has more than doubled versus 2007
- More liquidity: Bank liquidity is many times higher than in 2007. Furthermore, funding stability has increased significantly. These changes are due, in large part, to rules such as the liquidity coverage ratio (LCR), net stable funding ratio (NSFR), and total loss-absorbing capital (TLAC/MREL – pending final rules)
- Reduced trading inventory and illiquid assets: The prohibition of proprietary trading and changes in risk-weighting methodology have caused trading inventory to fall by more than 50% and Level 3 (illiquid assets) to fall by more than 60% on broker balance sheets. While this may well be leading to liquidity and volatility issues outside the banks themselves (i.e. with asset managers and other buyside participants), the brokers are undeniably more robust against market stress
- Reduced counterparty risk: Given the importance of bank counterparty risk, the improvement of all major trading partners should not be underestimated. In other words, the system is as strong as the weakest link. Regulators are also enforcing counterparty limits and central clearing of most over-the-counter derivatives, reinforcing market structure
- Regular exams: Regular stress tests reduce the likelihood of risk build-up and keep both regulators and bank executives attuned and engaged with one another. These tests continue to become more thorough and difficult as time goes on due to the layering of stresses, providing further comfort on bank durability.
Better structure, higher returns?
The underlying structure of the industry is improving and should continue to do so.
Market share is consolidating, with banks in Europe, in particular, shifting away from the most capital intensive market-making business lines; there is anecdotal evidence of improved pricing, the litigation peak appears to have been reached for most banks, and the end of re-regulation appears to be in clear sight.
There is also a structural growth story outside the US: while 80% of US non-financial borrowing takes place in the capital markets, Europe sees the reverse, with 80% of borrowing happening on bank balance sheets.
Given an increased focus on bank balance sheet efficiency, Europe’s bond market will likely increase significantly over the next decade, with Asia not far behind.
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Why aren’t banks better loved?
Despite the aforementioned improvements, many of these companies traded at current price levels, or higher, as far back as mid-2009.
Why? Well, for one, regulation is much tougher than what was imagined six years ago. Further, litigation expense has bled $200 billion and counting of shareholder funds.
Finally, unprecedented central bank involvement in markets has depressed both rates and volatility across major markets, reducing client activity levels and bank revenue.
I would characterise the above as reasonable reasons for less-than-stellar returns.
But, there also appears to be aspects of valuation that are being driven more by sentiment and fear than by fundamentals.
The logic seems to go as follows: Capital markets were the epicentre of the last crisis; therefore, any time there’s a whiff of stress (i.e. housing bubbles, European dis-union, China wobbles), sell the global systemic banks.
Investors should consider taking advantage of the disconnect between sentiment and reality.
I’m very aware of the danger in prognosticating on complex, global banks. After all, the next global crisis or scandal may be just around the corner.
Furthermore, some European banks still have ground to cover before reaching their capital and liquidity end state.
However, looking at the sector broadly, I see strength, stability, and constructive industry dynamics.
If correct, this should result in a significant re-rating in addition to dividends, buybacks, and book value growth while investors wait.
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