Rules are hurting profits; but banks still have a lot of fat to cut
THE activists from Occupy Wall Street and Occupy London, having braved the winter cold in their huddled tents, re-emerged to march on banks in protest on May 1st. Instead, they might ask themselves a question: is it good that the big bad banks that rile them so are barely profitable?
In America banks are earning an average return on equity of about 8%, which is less than their cost of capital. The only consolation for American banks is that they are doing better than Europe's, which have earned meagre returns of about 4-6% in most big countries. Given the riskiness of investing in banks, shareholders would have done better to deposit their cash in banks rather than buy their shares.
Having a banking system that is on its knees may please anti-capitalists, but it is a worry for firms, households, governments and anybody with a brain. Unless banks can earn returns that are sufficiently attractive to private investors to draw in capital, then they will suffer a slow decline. That could choke off credit to companies and households, damaging economies and diminishing growth.
Ask a banker what the problem is and he will say, “regulation”. There are indeed lots of new rules to contend with. As this newspaper has pointed out, many of these new restrictions are unnecessary, fogged by uncertainty or stuffed full of daft provisions and red tape: America's Dodd-Frank act is a glaring example. And regulators should worry about the profitability of those in their care, unless they plan to have the entire banking system nationalised. But blaming poor profits on bad regulation is only part of the story.
As the pips squeak
To begin with, the main change is sensible. The new “Basel 3” capital standards require banks the world over to have thicker buffers of capital to absorb losses. Under the new regime, banks will hold about three times as much equity as they did under the old one. The cushion could be plumper still in some places: Europe is split over how strictly to enforce these rules, and whether to allow countries such as Britain and Sweden to add yet another wedge of equity on top. All else being equal, higher levels of capital mean lower returns on equity.
That leaves regulators with an awkward balancing act. For instance, many of Europe's banks need to bolster their capital buffers, but few will be able to entice investors, since they promise such meagre returns. Banks will also struggle to generate the capital they need from profits. Many may simply try to reduce the size of their loan books instead. So squeezing them too hard does not make sense. But there are three reasons to suspect that that point has not yet been reached.
First, profits are bound to be smaller. The system ran on too little capital before. The returns on equity of 20-25% that some banks made in the years before the financial crisis were abnormally high. They are now closer to their historical average (see article). The cost of bank borrowing is going up as regulations relating to the “bail in” of bank debt and the orderly resolution of failing lenders are introduced. These new rules make it a bit less likely that governments will have to save banks and their creditors. Since a hidden subsidy is being removed, it is only natural that banks' borrowing costs should rise.
Second, it is hard to disentangle the effects of regulation from the state of the economy. In Europe, especially, and in America consumers and companies are rebuilding their balance-sheets; unemployment and property busts are also levying a toll of bad debts. In time things will improve, reducing provisions, increasing demand and bolstering profits. Many lenders reckon they will end up making a return on equity in the low teens, above their cost of capital.
Third, the banks could do more. The moans about their inability to make profits safely sounds all too close to the noises from old-style airlines before the arrival of low-cost carriers. The banks could cut people's pay: there have been welcome signs of assertiveness from bank shareholders on this score in recent weeks. And if that fails to do the trick, there is plenty of room for consolidation. Activities such as equity trading look overcrowded. Too much money is still being wasted on unrealistic investment-banking ambitions. Yes, some new rules are mad and meddlesome. But by the standards of other industries there is still a lot of fat to cut.
This article appeared in the Leaders section of the print edition under the headline "Balancing the books"
