Ahead of the Curve: Beware banks
The universal desire to generate economic growth through capitalism lends itself naturally to the long-term nature of pension funds. So it follows that investing in only the most outstanding companies, which most reliably and regularly produce real economic growth, is what pension funds should focus on.
High-quality growth and the patience of the pension investor will reduce risk and increase reward. Contrary to the belief of many industry commentators, pension funds stand the best chance of producing the low-risk, high returns over the long term from a concentrated portfolio of good-quality growth stocks. A mark of the astute investor is therefore what you should sensibly avoid to reduce risk. In this context, the risk presented by banks merits scrutiny.
Bank shares have performed well this year. Anticipated moves in the price of money have affected the banking business, or at least the perception of it. As the whiff of quantitative easing (QE) tapering pervaded the air, initial market reaction was to bid up bank shares in the expectation that the engine of lending was well and truly oiled and running on multiple cylinders. As far as it went, this argument was valid but represented only one side of the coin.
This year, US banking results have shown that the business of lending, as well as of investment banking, had indeed picked up. At the same time, however, securities trading had not yielded the expected returns. Lack of volatility in most asset classes was the culprit, it was said.
Some commentators even warned that the lack of volatility had become the new risk to the market. What prevents banks from returning healthy profits is bad for the economy, as the saying goes. After decades in which volatility in asset prices had (erroneously) been presented as a ‘risk’ to the shareholder, all of a sudden the lack of it has become the new risk creeping in through the back door.
This is nonsense, of course. The true culprit that prevents banks from making profits on trading their books is the Dodd-Frank Act that was presented as the solution to all problems. This act strongly curtails the amount of banking capital institutions can use for proprietary trading. The result has been shrinking liquidity and reduced player participation.
However, the act is now in danger of being dismantled by the administration of President Donald Trump, another sign of how the banking industry can be subjected to dawn raids by regulators. Over the next few years, more can be expected on this front.
The business of banking is closely linked to one of the greatest imponderables for financial observers – the interest-rate cycle. The core banking business of old focused on the incongruence of short-term borrowing used to finance long-term lending. This basic mismatch represented the banks’ risk. At the same time, as the difference in short and long yields indicated the success or failure of this strategy; this differential has become one of the leading influences on banking results and bank share prices.
With the election of Trump, expectations of a cyclical upswing in the US economy ran high and banking shares were perceived as leading beneficiaries. As their share prices rallied, momentum investors were tempted to overweight their portfolios with such investments. But what do bank shares really represent?
Many observers focus on the quality of a bank’s lending book as a measure of its viability. They forget that the most common cause for a bank failing is the deposit base drying up, or customers withdrawing their money in a flight to safety, or where there might be a serious mismatch on the maturity profile of liabilities and loan assets. These situations highlight a liquidity crisis.
Northern Rock is a classic case of where the bank was hugely reliant for its source of money on the wholesale deposit or capital markets, with too few deposits coming from customers. Banks are only as safe and reliable as their central banks permit them to be. This reliability is also likely to depend on the central banks’ monetary policy and their willingness and efficacy in bailing them out.
Banks are highly geared corporate entities where debt exceeds equity by a massive margin. Their dependence on the fluctuations of interest rates and the yield curve in bond markets makes their profitability hard to predict and their valuation difficult to measure.
As a result, confidence becomes the key factor that keeps banks in business. But confidence is fragile and tends to wax and wane with the business cycle and the mood of investors, depositors and capital markets.
Bank balance sheets are notoriously difficult to analyse. Looking closely at asset quality uncovers more questions than answers, as regulators discovered in the wake of the Lehman crisis.
But even a partial understanding of a bank balance sheet cannot include understanding assets and liabilities held off-balance sheet under the guise of contingent liabilities. This is where the trouble started in the US prior to the financial crisis of 2007. Not seemingly having learned their lesson, banks have once again built up assets and liabilities outside their mainstream balance sheets.
Returns on equity rarely reach and maintain double-digit percentages, and the long-term growth prospects of such businesses are often hampered by events beyond the control of banks’ management.
As 2017 progressed, disappointment set in, with the Trump administration viewed as unable to put its programme into swift action. The share prices of banks became as volatile as the spread between short- and long-term bonds.
If pension investors begin their contribution at the age of 20 and expect to live to 80, their pensions must be invested accordingly and the best possible results must be sought within a sound risk framework.
The quality-growth investor needs predictability of future earnings to place a value on them, with a view to calculating the potential for capital gains. This is not possible in the banking sphere. Balance sheet and management quality are often lacking; bank shareholders have enjoyed no steady, compounded growth over the long term; and the external interference of the interest-rate cycle as well as constantly evolving regulation and compliance rules make it impossible to forecast future earnings.
Therefore, the quality-growth investor is better advised to keep a close eye on the banking industry – but only from a distance.
Peter Seilern is the chairman of Seilern Investment Management