Worry when bank returns rise - Comment & Profiles -

Are concerns about low return on equity based on a false assumption about the cost of capital? Adjust that and the picture improves dramatically, writes Brian Caplen.

Everyone is worried about low profits and returns at US and European banks. The worriers include management, consultants, investors and even regulators, who before the financial crisis would not have considered profitability part of their domain. The consensus view is that the cost of capital is 10% or slightly above and that with returns on equity stuck in single digits, banks are destroying capital. No wonder they are unloved by investors.

Yet what if everyone is wrong about the cost of capital? There has been huge debate about the effectiveness of the best known measure – the capital asset pricing model – but on the basis that it is the best tool we have, does it currently give us double-digit figures for banks?

Not according to Scope Ratings which states in a recent report on European banks: “The market seems to constantly overshoot the implied cost of capital for banks, which is routinely placed in the low double digits (for example, 11% to 12%). For the large European banking sector aggregate we estimate it at about 7% to 8%, taking into consideration a current risk-free rate close to nil and bank betas converging towards lower risk more so than before the crisis due to tighter regulations and improved risk profiles.”

Now that doesn’t mean that banks can stop work on the huge task to make themselves more profitable by going digital and cutting costs. But current bank returns on equity (ROEs) reflect a situation in which capital ratios are higher, net interest margins are low and the balance sheet is safer and composed of low-yielding but more secure assets.

Scope’s team leader for bank ratings, Sam Theodore, says that bank ROEs in single digits should not be seen as a weakness provided there is a strong balance sheet and sound business model. “If ROE rose by one-third, then I would be concerned. What is the bank doing now that it wasn’t yesterday?”  

By the same logic, regulators should have heeded the warning signal when bank ROEs were in the mid-twenties and higher prior to the crisis. This should have prompted them to ask questions about how those profits were being generated. Worrying now about low ROEs is probably a false trail. Low returns are to be expected in the current environment.

Brian Caplen is the editor of The Banker. Follow him on Twitter @BrianCaplen

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