The “Perma-Short Banks”

by | Sep 23, 2020 | Corporate Governance | 0 comments

A look at whether the US banks are headed the way of Europe and Japan…

Spanish Bank BBVA: donating shareholders money to customers for 3 years running.
Euro”trash”: negative rates, low loan demand, poor governance

One of the reasons most US bank stocks have struggled to regain their levels of February is the belief that the US economy is following the path of the Europe and Japan, and the US banking sector is in turn following those countries’ “basket case” banks. This belief in our secular decline, popular with macro pundits and the pensions and endowments that follow them, is a sad prospect. Below we dig in on the details and risks.

Why are the overseas banks so bad? Year after year these banks capture more risk than reward – making ~6% ROEs with 30-40x leverage from laughable sub 2% net interest margins. They are too stubborn to free up capital by running off subpar assets to repurchase shares at 50% of tangible book or below. Some, like Deutsche Bank, compete with the profit-optional Landesbanken. Unreformed Spanish and Italian banks entertain zombie corporations in markets with 10%+ unemployment. These banks are pinatas for their clients and governments, with management teams passively absorbing blows instead of finding better uses of capital. You might compare them to coal companies – capital intensive with low margins – except they are systemic, so are difficult to kill and reorganize.

The issues are margins, expenses, governance, capital management, and government meddling. US banks are imperfect but the foreign banks are worse across the board, now and into the future.

Let’s briefly break down the differences

  1. Margins:

This is the primary reason the foreign banks have fallen apart. Margins overseas are 1-2%, and unless they operate all digital, banks simply have to take too much leverage to hit their 10% ROE targets safely. The US does have a few banks with margins dipping close to European territory, notably Wells Fargo at 2.2% despite not having a sizable securities arm, and JP Morgan and Bank of America at ~2% with large securities books. These margins are actually artificially low given recent jump in cash balances. In the US most regional banks run 3.0%, and expect stabilization or slight growth, while community banks are 3.25% – 3.75%. Putting that in perspective, US regionals run approximately double the spread of Europeans and 3x Japan. Below is an exhibit from Mitsubishi UFG’s September 10 deck. Embarrassing. USA 1, Japan and Europe, 0

2) Expenses:

In the US the new trend is to close branches. Not a few, but multiple banks have each announced 20% branch closures in recent weeks. PNC is closing 160 branches and Wells is looking to cut $10 billion in costs.

The Europeans are making an effort for second place:

Mitsubishi, among the biggest Japanese banks, is closing a few branches but still working on the 2010 playbook of branch revitalization, shown below:

In a narrower victory USA 2, Rest of Developed World 0

3) Capitalization:

4.2% leverage ratio is what Societe Generale considers “strong”:

4.2% is the level of the dumbest US banks in 2007. Citi ran 5.2% leverage in 2006 and hit 4.03% for the bailout win in 2007. Even Deutsche Bank, with its own 4.2% ratio today, admits this level is unacceptable:

Sumitomo as an example in Japan sports 5.57%

Today the one US bank of the big 4 that had to cut its dividend – Wells Fargo, carries a 7.9% leverage ratio.

USA 3, Rest of developed world: disqualified for hitting linesman with a tennis ball to the throat.

4) Governance / Return of Capital

Governance and capital go together because once a government or central bank tries to push its banking system around, that bank has the option of punishing shareholders, or managing around restrictions. JP Morgan is notable for navigating crises intact and returning tens of billions in capital on the other side. Even Wells Fargo, punished in part by an excel error in the Federal Reserve model, still pays a 1.7% dividend yield. Conversely the major Europeans are currently not even allowed to pay a dividend. They have only themselves to thank, for running ridiculously low core capital ratios. US bank share buybacks could reach $100 billion in 2021. Buybacks are not even a consideration in the other markets.

USA 4, Rest of Developed world – PAC 12 football (self disqualification).

5) Government meddling:

More and more ECB members have begun to understand that negative rates work in theory but not in practice. Like covid lockdown advocates, they persist based on theory instead of the reality around them. The Federal Reserve, even resident harlequin Kashkari, has repeatedly and wisely resisted this policy “unanimously.” Negative rates disincentivize lending, zombify borrowers and many believe reduce velocity of money.

Stay tuned for a Biden administration, but US banks outperformed Europe massively during Obama despite 0% rates and a tarnished reputation that has since been partially repaired.

USA 5, Uninvestables: 0

The US has a major debt overhang and low rates will be with us for years but our banking system is far ahead of the overseas banks in all important cultural aspects.

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