Tuesday, August 20, 2019

Thinking aloud about bank margins - Part 2

Part 1 of this series laid out a bleak future for monetary policy and/or banks. As interest rates go down so do bank margins and there are limits on how far interest rates can be cut because eventually they take bank margins below levels adequate to cover losses or even below levels adequate to covering operating costs.

If this is right ultra-low interest rates are non-stimulative because they stress the bank sector causing the bank sector to tighten (not loosen) lending. Monetary policy hits a wall of non-effectiveness and ultimately bank bail-outs.

This is essentially the Raoul Pal view of the world. He sees no policy way out of the next recession -particularly in Europe - because if you don't cut rates you are stuffed and if you do cut rates you blow up the banks and you are stuffed anyway.


As I said at the end of the last post I am not sure it is always so simple and/or so bleak. That is because ultimately there are two drivers of margins a weak one (Central Bank policy) and a strong one (the competitive landscape the banks face).

In Europe both of these are driving bank margins down for most but not all banks. But it doesn't need to be that way and more deft policy-makers have different options.

But to see why need to run you through a stylised history of banking margins.

Lloyds bank as the best bank in the world

Just over twenty one years ago The Economist wrote a glowing article about what was then a roll-up of British High Street banks. It was Lloyds TSB.

A glowing article about Lloyds seems peculiar now as the bank was bailed out in the crisis and has lurched from disaster to disaster ever since. But under the title of The Lloyds Money Machine the economist wrote the following:

... Lloyds TSB runs head-on into a problem that most other banks would envy: it simply earns too much money. By some estimates the bank is sitting on £3 billion more than it needs. It would gladly use this for acquisitions. But short of buying another big British bank and closing down hundreds of branches, which would almost certainly be blocked on competition grounds, it is difficult to imagine an acquisition that would be as profitable as Lloyds TSB's current business.

The bank had fat margins and was busy cutting costs. The article goes on:

Peter Ellwood, former boss of TSB and now group chief executive, believes that even without further acquisitions the bank can continue its impressive run by cutting more flab and by persuading its existing customers to buy more of its products. Costs have already been brought down to 52% of income, a low figure for such a large bank. Once Lloyds and TSB are allowed to merge, analysts at Dresdner Kleinwort Benson reckon, the bank could shut more than 800 branches without weakening its high-street coverage, thus saving up to £300m a year. Along with these savings will come proceeds from the sale of businesses that underperform. The bank is seeking to sell Black Horse, its estate-agency arm. Its small Latin American banking and consumer-finance network may follow.*

At the time Lloyds was the thirty-fifth biggest bank in the world by assets but the biggest by market capitalisation. It was hyper-profitable and traded at a svelte seven times book.

And then it all went horribly wrong. The bank took only a decade to be nationalised.

What went wrong was competition. At the time Lloyds revenue to risk weighted assets was 8 percent. This was the highest number I have ever seen on a major bank anywhere.

These fat margins attracted competition mostly in the form of Northern Rock and Fred Goodwin's Royal Bank of Scotland behemoth. These guys never saw a loan they didn't want to undercut. Revenue to risk weighted assets in British banks went down by 75 percent. If you do it as a percentage of assets revenue as a percentage of assets fell from over 5 to about 2.

The point of this is that this happened in a non-zero interest rate environment. Competition killed margins and excessive willingness to write loans meant that margins were destroyed just as credit losses ticked up. You can find a full set of Lloyds accounts from CapitalIQ downloaded here.

German (and Italian and Japanese) banking margins have been terrible as long as I have looked at banks. In both markets there was strong competition and a shortage of borrowers (at least relatively). Also in Germany there were aggressive Landesbanken who fulfilled the margin compressing role of RBS. It is kinda-nice when you fund yourself with a quasi German government guarantee. It is not nice to compete against someone who has a German government guarantee.

By contrast the oligopoly banks of Australia and Canada have made lots of money with a good economy despite being breathtakingly stupid. In banking - as in other industries - you make money out of market structure as much as anything.

Before everyone stuffed around with the definition of risk-weighted assets I used to compare revenue to risk-weighted assets by country. These are still roughly right in terms of profitability,

  • The thinnest margin banks in the world were Japanese with revenue to risk weighted assets of about 1 percent.
  • Then were the Germans and the Italians at about 2 percent
  • The Americans were in the middle - between 4.5 and 5.5 percent with a single outlier - the most effective major bank at screwing their customers in America - and that was Wells Fargo. Wells Fargo was about 6 percent.
  • Then there were the highly oligopolistic Canadians at 6-6.5 percent.
  • Finally - the fattest margin banks in the world were Australians. And that was at 8 percent. 

Our friends at Lloyds went from 8 percent at the time of the article to something in the mid 2s now. The world wasn't quite turning Japanese - but maybe turning German.

But there are outliers - and some of them are surprising. The Irish Banks look in Ireland pretty darn profitable. The Scandinavian banks are alright too - despite (say) Swedish interest rates going negative before everyone else.

Even some French regional banks are okay.

And these banks are profitable even in a negative interest rate world.

Swedish banks faced negative rate early - and they came out kind of well.

If central bank policy is going to work the central bankers are going to need to learn from the banks that have maintained reasonable profitability in the face of negative rates. This may be the single most important lesson for central bankers in the next decade.

If I knew all the lessons I would tell you. I don't. I know several of the outlier banks but nailing down quite why they are outliers is hard. But I will look for you.

Till next time when I will have a look at the outlier-banks.


PS. Whilst for years I used revenue to risk weighted assets as a measure of profitability it doesn't work that well anymore because of changes in the definition of a risk weighted asset. For the next post I just intend on using revenue to total assets. It tells the story well enough.

*For the record the (retrospective) silliness of that Peter Ellwood quote didn't seem to hurt him later in his career. He got his knighthood somewhat later.


Sandymount said...

Would be interested to hear how you might handicap the extremely cheap banks in less comfortable jurisdictions like Sberbank or Halyk Bank Kazakhstan etc. Is there no valuation one would buy these because of location/geopolitics etc for example.

reasonable efforts said...

Part 2 seems more on point than part 1. When a banker prices a loan to its borrower, typically it is priced using benchmark+margin (e.g. LIBOR+250 bps) and the margin is supposed to reflect mainly the credit risk of the borrower (plus cover for that bank's cost of funds above L) - so the fact that interest rates are lowered by a CBR is not supposed to really affect margins - the benchmark may fall, but it does so both on the asset side and liability side of the bank, so the effect is essentially neutral. Lower interest rates per se should not affect lending margins.

Margins reduce when either the credit risk is lower, or when there is too much money chasing too few deals - i.e. supply/demand drives pricing lower. Now, QE of course increased the supply of money, which meant that banks have become very liquid, meaning there is pressure to lend and hence margins (i.e. pricing) goes down - so "excessive QE" may result in the effect that is being discussed - i.e. banks' profitability reducing to a dangerous level... Coupled with pressure to deploy capital and resulting pressure to take excessive risks this leads to a rather dangerous situation.

Anonymous said...

Hi John,

we did a bigger empirical Analysis on the future profitability (ROEs) of banks. The real intent was to determine if our analytical Framework was correct. However, if you look at table 6 when trying to determine ROE in 2 years time, the main economic determinants are loan loss rate (better underwriting), higher fee margins (cross-selling and more resilient in downturns) as well as cheaper deposit funding (better at customer Relations?). Capital Levels are not really relevant.

This covers only the micro-determinants, and not the macro-determinants such as market structure. But should give some insight into how a bank should be managed.

Esterer, Florian and Grossmann, Stefan and Schroeder, David, Analyzing Banks: Management and Investor Perspective (February 14, 2013). Available at SSRN: https://ssrn.com/abstract=2217827 or http://dx.doi.org/10.2139/ssrn.2217827

Cheers, flo

Unknown said...

Hi John, Thanks for this series - very timeous and critical topic. I am not a macro guy but I have been trying to noodle a bit on what the effects of the central bank actions since the crisis on the monetary and banking system really are (being that we are in such uncharted territory here and that the central banks seem determined to keep using the same old "hammer" despite it having patently not produced the desired magical 2% inflation rate). So far it seems to me that the "monetary realism" view of money (essentially almost all money is created by the private banking system when the banks make loans and the central bank plays mainly a regulatory and facilitating role) does a better job of explaining the mechanisms than traditional monetary economics. It also gels fairly well with what you have been saying so far in this series. Have a look at Cullen Roche's primer on monetary realism: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1905625 for a start if you have not already.
Thanks again,

Anonymous said...

Intriguing posts. The one aspect explaining the margin differentials between banks within an economy is business model diversification. In boom times for each banking segment, “monoline” banks who are heavily weighted towards a segment will produce superior margins and returns. In downturns they face heavy losses and may end up in taxpayers’ arms. Diversified banks cannot deliver the same peak profitability but are more likely to survive a crisis. Bad underwriting and stupid M&A deals obscured this dynamic during the GFC. But if you look at the divisional data of the surviving banks over the years (banks with activities spanning from retail to IB) you can observe how the dynamic works. IB goes down while retail is profitable. IB has already recovered when retail goes down. There is a time lag between these segments - they react to macro changes at different speeds. Another thing obscuring this is the fact that diversified banks change their divisional reporting structures constantly. The trade off is something on the lines of giving up periods of peak profitability in exchange for a higher probability of having a surviving diversified bank vs. several dead monoline banks. -Ojm

Unknown said...

Here is the real problem with negative rates for deposit facilitie at the ECB. Deposits becomes a source of cost, not income. So banks, at least in Spain, have decided to move clients from deposits to more commission generative products like investment funds and pension funds. These products are very profitable, but here comes the problem. The main business of a bank is gathering deposit to provide loans. If you intentionally reduce your deposits, then at the end of the day you are reducing the loans that you can grant. So eventually you are unleveraging the economy and monetary policy is not as accomodative as expected, but just the oposite.

john b said...

I know John knows this - but for the benefit of readers less well-versed in UK banking, it's worth noting that Lloyds's collapse and part-nationalisation was not *directly* caused by the falling margins listed in the piece.

Lloyds entered the GFC in reasonably adequate shape; it would definitely have ended up taking a significant hit on its UK commercial portfolio and had some (but limited) exposure to Ireland, but would in its own right have made it through the crisis.

The problem was that in September 2008, due to some combination of over-optimism and government pressure, Lloyds agreed to step in to rescue HBOS, one of the challengers that had eroded UK banking margins over the previous decade, which was almost as much of an over-extended basket case as better-known RBS.

Lloyds thought that - with the government desperate to save HBOS from falling over - it would be able to increase its market share without competition authority meddling, and that HBOS would be a price worth paying. But HBOS turned out to be so absolutely colossally bust that even the merged entity couldn't absorb its losses.

Anonymous said...

looking at this from a different perspective - it could be that the extraordinary central bank policy actually helped boost bank earnings in the short-run by keeping zombies alive and adding so much liquidity into the system.

I also think, especially in Europe - regulatory overkill has hurt bank margins significantly. More and more capital being forced upon the banks with Basel 4 to come. Total capital ratios are 17.99% according to ECB stats. Thanks for the posts.


Jonhdoe said...

As a bank analyst for some time, I generally find that the secret sauce for bank profitability (at least in developed markets) is a combination of:

- Low cost-income: low structural cost base (limited number of employees, larger but fewer branches, high usage of digital/mobile banking, lack of inertial labour cost increases (unions),...) and high concentration (CR5 or Herfindahl, drives margin expansion). Positive jaws (income growth > cost growth) is a must.
- Income growth driven by strong franchise (cross/up selling) or business model (retail vs wholesale, originate to distribute,...).
- Credible management, demonstrated loan underwriting capabilities and "rational" IT capex (a large share of investments in digital transformation have yet to bring value to shareholders).

Mix them up and you get decent RoEs and P/BVs>1 in spite of the negative rate environment.

Is there something else you would add to the mix?

sean said...

This is a very good piece. I always thought the low rates - bad for banks story was wrong, but this explains it well.

Banks fund their assets with 2 things equity and borrowing themselves. While the equity part gets a lower return the lower rates go the borrowing/lending part is just a spread. If they borrow at -2% from the ecb but lend to customers at 1% thats still a nice spread.

Jonah Larson said...

You missed one fantastically managed American bank with revenue to risk-weighted assets of 9%.

Capital One Financial Corp.

Anonymous said...

Luckily the stock market is multi-dimensional and the analysis on the attractiveness of investing in banks does not stop at the margin. Clearly ROEs will be challenged in a low interest rate environment, but it does not mean that the banks are uninvestable.

Lets look at some of the positives. First, the risk profile both on the asset and liability side of the balance sheet of European banks has changed dramatically (lower) post financial crisis. Second, the amount of equity supporting these institutions has increased significantly. From an underwriting and quality of earnings standpoint these are relevant points.

The good ones, like Lloyds, are still earning a pretty good ROE once you remove fines and restructuring charges which have distorted the analysis.

Finally, and perhaps most importantly, the price you have to pay is far lower than almost anytime in modern history for large and important lending institutions. There are perfectly fine banks in Europe (many of which have already met or exceeded Basel 4 requirements) that will earn normalized ROEs of 9% -13% in this environment that are trading between 35% and 90% of book value.

Phil said...

As far as I can see when people talk about bank margins they too often neglect the funding side. A bank is profitable if it can raise funds at lower rates than it can lend them out. At 10x leverage a 1% difference between your cost of funds and your loan rate and your getting 10% gross return on capital, add in costs etc and you might hope for half that. In Europe the ECB has been trying to push down loan rates from banks to consumers via a bunch of channels, without cutting interest rates. They have also been unwilling to pass negative rates onto consumers, which ultimately results in higher funding costs for the bank. Another 1/3 of their funding comes from bonds. A lower repo rate translates into cheaper funding for the banks over time, which is supportive, but again the EU regulators have created a problem as by creating various regulatory burdens the banks have met them by issuing cocos, but ultimately the bank has to pay up for the implied optionality there and that means higher costs of funding.

The reason US banks are grossly more profitable is largely the weird structure of the US mortgage market underwritten by the GSEs. This means that US consumers get 30y fixed mortgages, with the duration risk underwritten by the GSEs that means that the banks get a much wider lending margin between their funding costs and their residential mortgage book, as the banks get to pocket both the term premium and the implied option premium for writing a callable 30y loan. Compare this to UK banks where the whole market is 2yr fixed.

(This has other implications for the yield curve, notably that because mortgages are fixed the pass through from fed hikes to the consumer is notably weaker, and hence US rates are systematically higher than most G7 comparators).

It seems to me that the ECB/regulators have two ways out, one is to act to systematically lower the banks cost of funding via regulatory relief. The second is to continue to lower interest rates while engaging in QE and other measures to lift inflation and hence steepen the yield curve.

Even if they don't, a few bankruptcies will lessen the competitive market and increase the spreads for consumer loans, which will be supportive of banks. Appreciate why they dont want to do that, but it does sometimes seem that the EU is massively overbanked now that they have effectively forced them to exit their overseas market via regulatory pressure.

random itinerant said...

Two blog posts about bank margins so far and not a single word about the prospect of fiscal stimulus and the impact it will have on yield curve and bank profitability...

Monetary stimulus may have run its course and become ineffective but it is not the end of the innings. Next up to bat is fiscal stimulus. Even the austerity-loving Germans are gearing up for it. In the U.S., fiscal stimulus in the form of infrastructure spending is one of the few things (perhaps the only thing) that Trump and the Democrats will be able to agree on.

Fiscal stimulus -> funded by increased supply of long-dated government debt -> lower prices (= higher yields) on that debt -> steepening yield curve -> improved profitability for banks and insurance companies.

By the way, did you see that Andrew Left (Citron) is now a Valeant bull? Any comments on that? :)

Is Valeant (now known as BHC) still going to zero just like Fairfax Financial and Alibaba?

Dudebro said...

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