The writer is managing partner and head of research at Axiom Alternative Investments
Large European banks have an excess capital of more than €500bn. For listed banks, this represents 43 per cent of their market value.
In a world where banks were free to remunerate shareholders as they wished, while keeping capital above minimum requirements, they could pay 43 per cent of their entire market value as a special distribution. This is a stunning number. And yet, Europeans banks trade on an average valuation of 0.6 times of their book value.
This is not new: banks have been trading at low valuations for a long time. For years, the blame was mostly on negative rates, hurting profitability. The reversals of monetary policies worldwide have changed that, and expectations of banks’ profitability has risen sharply.
So, what is going on? Back in the mid-2010s, there was an old joke about banks’ excess capital: as a shareholder, you’d be a fool to believe it belonged to you, because it belonged to governments. They would take it through fines for past misbehaviours or new capital requirements. But that also is a story of the past: the Basel IV revamp of banking regulations is almost finalised and global litigations are falling fast — except maybe for a few banks.
Have governments found a new way of “taking” banks’ excess capital? There is a theory gaining traction that our times are eerily like the 1970s with deflation, recession and energy shocks etc, and that, as in the 1970s, this will lead government to control banks and credit excessively — something that will ultimately hurt shareholders.
There are indeed some worrying signs, of which I will describe four. At the onset of the Covid-19 crisis, the European Central Bank imposed a blanket dividend ban, whatever the strength of the bank’s balance sheet. This was justified not only on solvency grounds but also because banks “needed to continue to fund the economy”. The underlying assumption — banks must act in the general interest, not in their own — sounds very noble, but is also not usually associated with private companies. Banks should normally be free to contract or expand their balance sheet depending on their perceptions of the economic environment.
Additionally, during the pandemic, a large share of new loans were guaranteed by governments. In theory, a bank’s role in the economy is to allocate capital and assess risks. When they lend hundreds of billions with state guarantees, they are effectively transforming a big part of their balance sheet into quasi-government entities.
The rise of environment, social and governance factors is also directing banks’ lending more. This works in subtler ways, with complex regulatory disclosures and veiled threats of higher capital requirements, but the conclusion is the same: bank lending is channelled to some specific sectors, based on considerations that are not entirely financial.
It is very easy to understand the dramatic need to fund the low-carbon energy transition, but discussions around the taxonomy or exclusion of some sectors such as weapons are more difficult. Bank shareholders might have the impression that they are asked to do the job of lawmakers afraid to take decisions themselves.
Finally, recent tax developments have reinforced the idea that a bank’s money is government’s money: after years of depressed returns, some countries (such as Spain and the Czech Republic) have decided to impose a “bank windfall tax” to offset the effect of new monetary policies.
The financial impact remains modest, but investors are afraid of generalisation and permanency, especially as central banks face large losses on their quantitative easing bond-buying programmes as interest rates rise — losses that will be passed on to governments. The temptation to recoup those will be huge.
Still, I believe we should not exaggerate those trends. Most lending remains unconstrained. Moreover, Covid was truly an unprecedented event and the argument that “there will always be another crisis to justify government intervention” is a bit weak.
But this should be a warning. A world of low rates has brought us capital misallocation. It would be a shame to replace one misallocation with another one. From 1972 to 1985, France had a quantitative credit control system. A few years after it ended, the country faced its “worst banking crisis since World War Two”, according to the Senate, and part of the damage was done by 13 years of credit control. We should not repeat those mistakes: strong banks make a strong economy.
Axiom is an investor in bank shares and bonds