Since 2009, global stock prices have rallied significantly. Financial stocks have increased, albeit off a low base. Some banks are up by more than 200 per cent. Central bank policies, especially low interest rates and large liquidity flows (from central banks through quantitative easing), have underpinned bank earnings to a large degree.
Low short-term policy rates act as a de facto subsidy to banks. This benefit can be estimated by assuming that deposits attracting near-zero rates are invested in risk-free government bonds to generate carry income.
Assuming it could earn a 2 per cent net spread between UK government bonds and deposit rates, Barclays would have earned around £8bn on deposits of over £400bn – more than its actual earnings, even taking into account extraordinary items.
In effect, the bank could have generated the same profit without engaging in any banking activities, purely by investing its customers’ deposits in government bonds. The position of other major UK banks is similar.
Focus on earnings changes beloved of stock spruikers, without regard for true earnings potential, can be misleading.
Monetary policy also boosts bank earnings indirectly. Low rates have stimulated a recovery in the UK housing market. Low rates have helped the values of mortgage-backed securities and other risky assets recover, improving earnings. Low rates also allow vulnerable borrowers to carry high debt levels, reducing levels of non-performing loans.
But as banks become instruments of policy, holding greater levels of government securities, deterioration in sovereign quality or rising interest rates expose them to the risk of large losses. A reversion to normal interest rate conditions would also reverse other identified positive earnings effects.
Policy actions also disguise weaknesses in traditional businesses.
Lower loan volumes, reflecting widespread de-leveraging by corporations and consumers and reduced economic activity, will limit earnings growth. Corporations are increasingly choosing to finance directly in capital markets, further reducing loan volumes and earnings.
For UK banks still active in investment banking, the revenue outlook is unclear. As the broader economy stagnates, trading volumes have declined. Proprietary trading is now restricted or attracts high capital charges, reducing its contribution to earnings. Derivatives revenues will be affected by the migration of activity to central counterparty and a clearing model.
Income from advisory work, mergers and acquisitions, new debt and equity issues is below pre-crisis levels, reflecting less activity as well as competition from smaller, boutique firms and internalisation of this work within large corporations.
Bad and doubtful debt provision reversals, which have been a significant source of “earnings”, are non-recurring items. The reductions were justified by the improved economic and credit outlook.
But the risk of loan losses is increasing in a weak economic environment with rising rates; and this risk is compounded by restructuring and refinancing of poor quality exposures that deferred but did not eliminate potential write-downs. Regulators have expressed concern that the industry is using lower loss reserves to increase reported earnings.
Banks also face higher funding costs, which affect their margins but also their competitiveness as cost-effective finance providers. They also face potential write-downs of goodwill on expensive acquisitions as well as deferred tax assets (resulting from losses) if those acquisitions cannot be used in a timely fashion.
Litigation costs remain a big uncertainty. Since 2008, global banks alone have incurred more than £100bn in legal costs. Further large fines are likely to be imposed to resolve legal issues, such as rate manipulations and mis-selling of financial products. It is not clear whether banks have made adequate provision for these.
Banks also face greater compliance and regulatory costs. Higher capital levels, reduced leverage and the requirement to hold more prime-quality liquid assets, combined with higher costs of capital, will reduce earnings and returns on equity.
Returns on equity have fallen sharply to high single or low double figures, well below pre-crisis returns of 15-20 per cent. Financials are unlikely to return to pre-crisis performance levels.
Complicating the outlook is the growing complexity of banks’ reported earnings. Results now include significant adjustment for arcane items such as FVA (funding value adjustment, reflecting the cost of borrowing to fund collateral lodged when hedging an uncollateralised trade with an offsetting collateralised position) and DVA (debt value adjustment, reflecting changes in the value of a bank’s own debt).
These opaque and subjective adjustments are only comprehensible to gnomic accountants, making it difficult to evaluate a bank’s actual financial performance.
Investors in banks are ignoring the source of underlying earnings and the fundamental business outlook, choosing to substitute (in the words of George Bernard Shaw) the “obsolete fictitious for the contemporary real”.
Satyajit Das is a former banker and author of ‘Extreme Money’ and ‘Traders, Guns & Money’