Banks really aren’t that complicated
We tend to make a lot of fuzz around banks and their complex balance sheets, but as Andy Haldane already pointed out a decade ago in his famous “The dog and the frisbee” speech, the simple measures often have a better track record at predicting bank risks than the complex ones enforced by regulators.
New research about the predictive power of Return on Equity (ROE) points in the same direction. At its core, banking is supposed to be a boring and relatively low margin business of borrowing money from depositors and lending it out to businesses and households at longer duration and slightly higher interest rates than what banks pay to deposit holders.
Unfortunately, banks compete with each other, and the share price of banks is in no small part driven by how profitable the bank is. Before the financial crisis of 2008, most banks aimed to get their ROE as high as 20% but these companies have since been disabused of that idea.
Today, most banks aim for ROEs of 10% or higher. Yet, no matter the target, higher profitability is only possible by taking on more risk. And while riskier loans pay more in good times, they also tend to be the ones going belly-up fast when times get tough.
In a previous version of their research, the authors could show that simply looking at which banks have the highest ROE in their peer group is a great way to identify which ones got into the most trouble (and sometimes went under) during the financial crisis of 2008 as well as previous banking crisis in the US, such as the Savings & Loans Crisis in the late 1980s.
Now, they have updated their research with the fallout from the default of Silicon Valley Bank (SVB) in March of this year. And still the world of banking remains as predictable as ever. The banks that had the highest ROE before the demise of SVB were on average the ones that suffered the most during the crisis.
In essence, investors should use ROE not as a measure of profitability but as a measure of risk. And in that respect, I am inclined to say that investing in banks has become riskier in 2023 on average. I haven’t looked at which banks saw their ROE grow the most in 2023 and which ones currently have the highest ROE in the sector (or rather, I have, but the results are not publicly available), but I think investors should really ask themselves if they want to invest in a massive black box (and that’s essentially what modern banks are) that just saw its profitability grow substantially? What goes up must come down and in banking that seems particularly true.
Bank ROE in Europe and the US
Source: Liberum, Bloomberg
I would like to start by saying that I will refer to credit institutions by their names. If this is not appropriate, you can delete the message, anyway are all public facts. In Italy, the situation of the banking sector is simple. Over the years, savers have lost millions of euros due to the mismanagement of the boards of directors with the collusion of the authorities that should have controlled them (the latest case is the Banca Popolare di Bari); involved in particular the so-called popular banks born to favor credit to small local realities but that often burned savings in risky operations for the benefit of “friends” and “wise guys”. They offered mortgages in exchange for the subscription of subordinated bonds or OTC stocks. Due to this situation, Banca Intesa, the largest Italian bank (it is one of the two Italian banks in the list of systemic banks, the other is Unicredit which now has its own problems), manages to collect savings and grant loans allowing itself to offer poor conditions compared to those offered by its competitors, both for those who invest their savings and for those who ask for a loan. This is thanks to the fact that the terrified saver decides that it is better to give up returns but at least he is confident about the "thrustworthiness" of the bank. Banca Intesa then plays on this psychological advantage by placing its poor investment products (emblematic that it does not offer deposit accounts but only "structured" products). So Banca Intesa offers e.g. unit linked insurance to the pensioner who does not realize that he would do 100 times better by investing in a deposit account in another bank less “prestigious” but that with today’s rates returns 5% gross. And this represents one of the reasons for the low confidence in the markets by Italians, in addition to a poor financial culture.
Super interesting article! Thanks for sharing.