Most banks in developed markets are trading at a steep discount to reported book values. Taking the UK market as an example, current market valuations for the listed banks are just c.40% of reported book valuations, a historical low. Indeed, the Irish banks trade at an even steeper discount, with market valuations sitting at just c.25% of book values. This article seeks to explore what lies behind the discrepancy between market and book valuations in the banking.
Mainstream incumbent banks are facing a wave of challenges that underpin historically low valuations. The chief challenge is low interest rates. Banks earn the vast bulk of their income and profits from interest-generating activities. Put simply, when base rates are high, bank profitability is higher. Prior to the onset of Covid-19, lacklustre anticipated inflation rates pointed to a structurally lower for longer rate environment in developed market economies. The pandemic has aggravated this. Indeed, the potential for the BoE to introduce negative base rates has become a real prospect of late. Even if inflation expectations do not remain anchored and we see rising prices in response to unprecedented fiscal and monetary stimulus efforts – which have a much greater impact on broad money supply than previous rounds of QE did – central banks may be slow to lift rates given the benefits of high inflation in a Government Debt / GDP erosion context. All this points to an ongoing – and, potentially, worsening – climate for banks’ interest income streams.
Other earnings-related challenges include the subdued environment for growth in banks’ core markets as well as large legacy cost bases. Focusing on the latter, while most bank management teams have already expended significant effort in cutting costs through a combination of headcount reduction, process optimisation, and physical footprint shrinkage initiatives, Cost/Income ratios remain elevated relative to fresh competitors. Indeed, a further interrelated challenge for mainstream banks is the continued spending needs to address shortcomings in their core infrastructure and processes – necessary ‘maintenance capex’ to compete with new players. Indeed, some newcomers may prove highly disruptive, presenting existential challenges for incumbents.
Another highly significant issue is the question of credit impairments, i.e., loan losses. Most banks have bulked up credit provisions substantially in response to Covid-19 but serious question marks remain regarding provisioning sufficiency. While banks have published their expectations for loan losses under various economic scenarios, it remains to be seen how well the models will work in practice given the unique nature of this crisis – with potentially significant consequences for the strength of current estimates for both probability of defaults (PDs) and losses given defaults (LGDs). A seasoned investor knows that the outlook for further impairment charges is highly uncertain and is baking in the risk of more loan losses into their forecasting and/or their risk assessments.
High impairments dampen near-term returns and, more importantly, the book value of equity. Additionally, the value of other assets sitting on bank balance sheets like sovereign debt and RMBS could also decay – for example, if market conditions deteriorate and/or if inflation expectations increase – serving to drive down reported equity values further.
Finally, bank capital positions face headwinds owing to the implementation of the final package of Basel III bank reform measures. These reforms are set to be introduced on a gradual basis from the beginning of 2023 and will serve to increase the quantum of capital that banks need to maintain relative to risk exposures (e.g. loans). This means banks will need even more equity to churn out the same profits for investors as they do today. Not only will this serve to reduce returns on equity further from today’s position, but it will also have the effect of diverting profits from dividend and/or capital return buckets to company coffers and may even see some banks forced to raise equity, thereby diluting shareholders’ returns.
Putting it all together, there are clearly multiple challenges in an earnings, a book value preservation, and a capital requirements context. Investors know this. Equity investors require a return on their monies, i.e., the cost of equity. This hurdle rate seeks to capture the opportunities and risks associated with the investment in question. Given the uncertainties and challenges facing banks, returns on reported equity expectations are weak – and typically materially beneath investors’ required returns (or cost of equity). Therefore, bank market valuations have adjusted to a level that can preserve the required return requirements associated with a fresh equity investment in bank stocks. An example, ignoring future growth for simplicity, is where Bank XYZ is expected to deliver a return on equity of 7% but investors’ require a return of 10% for investing in the equity. An investment institution will only invest if it can acquire stock in Bank XYZ at a 30% discount to book value (i.e., (10-7)/10). So, market forces drive the stock price down to this level.
While the outlook for banks could become even more challenging, the good news is that the market is already factoring in considerable downside. The equity risk premium is at a historically high level. The emergence of any certainty around the extent of economic damage wrought by Covid (a vaccine would help!) and where the trough lies for base rates could see an adjustment to required returns, thereby benefiting bank valuations. Indeed, some clarity in terms of a return to dividend distributions would also stimulate a greater level of appetite for bank equity among investors.
Indeed, there are some areas where banks can help themselves too. Certain management teams have proven their ability to nimbly recalibrate strategies in response to the challenging interest income backdrop. Non-interest income streams are valued at a premium to interest income streams. For example, Lloyds has intensively focused on the development of its bancassurance business model as well as seeking to benefit from demographic change by emphasising its wealth management offering, which also presents significant optionality in an excess deposits deployment context . Barclays is pursuing the development of revenue streams in ‘capital-lite’ segments like payments and transaction banking that are complementary to its core lending proposition.
Consolidation is another topic in receipt of close attention given Europe’s highly fragmented banking markets. While M&A can provide a partial fix, it is not without risk. Indeed, there also appears to be serious misunderstanding concerning the use of badwill.
Finally, the disruptive change underway as banking digitises can be an opportunity as well as a threat. Banking is a scale game. Interestingly, as the pilot partnership forged between Google and Citi in late 2019 shows, there are ways in which Big Tech can be constructive. It seems reasonable to assume that Google doesn’t want a banking licence and all the associated regulation, but it can take a slice of the economic pie while providing enhanced distribution opportunities for Citi. The incumbents are best-placed to capitalise as this model gains traction. Winners and losers are sure to emerge as the industry rapidly transforms. Change brings opportunity for the right management teams.
Author: John Cronin is a Financials Analyst with Goodbody Stockbrokers. To find out more contact your financial adviser