How can European banks make themselves investible?

Like an explorer attempting the first winter crossing of Antarctica, banks face a long, difficult journey full of material risks. The risks banks face arise from multiple external pressures including the global debt burden, interest rates at the zero bound, and ever tighter regulation. They are also challenged by various internal constraints, more of which later.

Yet banks are not starting their journey from a position of strength. Not only have they failed to satisfy their external stakeholders, but the returns to shareholders have been inadequate over both the short and long term. These poor returns on equity are set to continue given the pressures facing the banks are structural, not cyclical, in nature.

Banks must therefore change, or be changed, if they are to deliver sustainable returns to shareholders and satisfy all stakeholders. The need for change is all the more urgent now that the 'search for yield' has resumed and the relative pricing of risk is collapsing. It feels like 2006/07 all over again.

Radical reponse

The necessary changes require input not just from the banks themselves but also from regulators, politicians and the central banks. For regulators and politicians, key areas to address include: structures (operating and ownership), capital (levels, instruments, etc), incentives, and uncertainty over bank asset values. Critically, regulators and politicians must change the incentives which govern bank behaviour as well as the rules.

Berenberg's most radical suggestion would be for banks to be funded with non-public equity in order to permanently change the incentives. Being listed on public equity markets puts bank management teams under significant pressure to grow at faster rates than are sustainable in the long term (this matters, as growth has invariably been bad for banks). We would also like to see investment banks separated from retail banking and returned to the private partnership model, in order to better align all stakeholder interests.

Introducing non-public equity after the event is extremely difficult – except perhaps for banks now under government control. Instead, governments might seek to bring about a change in funding structures through tax breaks. Yes, governments would forgo current tax receipts but they would also reduce future bailout costs. Such tax incentives might also encourage banks to break up their operating structures, splitting commercial banking from investment banking, etc.

Capital inadequacy

Previous efforts to improve the type and quality of capital as well as the amount have not gone far enough in our view. Further reform should include: making equity to assets the primary metric for assessing capital needs; introducing new capital instruments such as Capital Adequacy Buffer Securities for investment banks; and incorporating growth rates into the capital ratio surcharges for individual banks.

As noted, incentive reform is potentially more important than changing the rules. We believe that dividends are part of the solution not the problem; a high dividend payout ratio would limit a bank's ability to grow and therefore take on excessive risk in the future. A bank also needs to be allowed to fail. The so-called 'Geithner doctrine' in the US, whereby large banks have been preserved no matter what the consequences, has further distorted the proper pricing and management of risk.
To remove investor uncertainty over bank asset and equity values, we would look to a top-down, pan-European audit of bank balance sheets. Pivotal to restoring confidence in the Japanese banking system in 2003, it has so far been only partially attempted in Ireland and Spain.

Utility banking

Internally, banks’ business models appear increasingly flawed with misaligned incentives and complex structures compounded by inappropriate governance and accounting frameworks. We therefore look to banks to reconsider their growth obsession and risk appetite, as well as the scale and complexity of their models. The outperformance of Handelsbanken's share price versus other banks and the broader European equity market for more than 30 years suggests that the utility banking model holds the key to more sustainable returns in banking. The future winners will be those banks which acknowledge the structural change facing the industry and embrace fundamental restructuring beginning with a de-risking of their balance sheets.

Finally, central banks. They have perhaps the most important role to play. They must kill the central bank put option in order to restore the uncertainty so critical to capitalism. They also have the power to engineer a permanent solution to the crisis by bringing about a permanent reduction in the debt burden which lies at the very heart of the problem. This requires inflation. While this has consequences for many, for banks it is the least bad solution.

Ultimately, all stakeholder concerns must be addressed, not just those of shareholders, if shareholders are to see sustainable returns. The very long asset lives and tail risks of banks means that the interests of shareholders and other stakeholders are aligned. We look not just to the banks but also to the regulators, politicians and central banks to bring about the required change if banks are to succeed in the difficult journey ahead of them.

Nick Anderson is senior bank analyst at private bank Berenberg.