How Banks Will Struggle With Finance’s Long, Slow Decline Capital rule changes will be finalized by December
Roll on 2017. The two big unknowns that have been threatening Europe’s big banks should be gone by the end of this year.
An optimistic view says that removing these overhangs can trigger a revaluation of lenders who will finally know for sure how much capital they need. But investors should be cautious. Banks are still too big for an industry that will continue to shrink around them.
Unlike U.S. peers, large European banks have yet to settle the last big postcrisis probes related to mortgage-backed bonds. Their second problem comes from global capital rule changes that will hurt banks that rely on sophisticated internal risk models to hold down capital requirements. U.S. banks have paid the fines and never relied so much on low risk weightings.
Deutsche Bank stock has been roiled recently by fears that its mortgage fine might be more than it can really afford. But the silver lining is that the process is under way. Many other Europeans also hope their cases can be closed before the year-end.
Similarly, the capital rule changes are due to be finalized by December. There are costs to both these things, but at least with certainty, the view into 2017 and beyond should be clearer.
Banks should finally be able to decide unequivocally what lines of business work and so better meet the performance promises they make. Returns on equity for many will still struggle to reach 10% in an ultralow interest rate world, but what returns there are should at least be reliable.
But there’s a problem with this thinking, especially for investment banks. Ultralow rates, which hurt lending margins, may eventually rise, but other revenue-limiting changes in financial markets are still in early stages.
Global investment bank and trading revenues have marched steadily lower, dropping by about 15% in total between 2010 and 2015, according to research firm Coalition. Some of the fall in trading and investing activity is cyclical. But what is less understood is the effect of changes in how money is managed and the pressure on fees and revenues everywhere in finance.
The rise of passive investment funds, which trade far less than other funds, still has further to go. Global assets under management in passive funds are still only 20% of the industry, according to Morningstar.
Hedge funds, once a huge revenue source for banks, aren’t yet shrinking dramatically, despite the wave of big-name closures, such as Perry Capital. But they are trading less due to pressure to cut fees and less access to leverage.
Behind all this, companies, investors and regulators are questioning what they get for the fees paid to the financial sector. Increasingly, it seems that a special period of deregulated finance when banks made huge returns and traded at high valuations is over.
In the century before the 1980s, most banks like those in the U.K. only ever traded at 60% to 80% of book value, according to Frontline Analysts. Valuations like that may be the best investors can expect for years to come.
