Sunlight on U.S. Banks
by Mark R. Kiesel
- Among global banks, we believe U.S. banks are in a stronger position to absorb deterioration in the macroeconomic environment in Europe. U.S. banks also look relatively attractive given their profitability, improving asset quality and capital position.
- Global banks vary dramatically in their asset quality and ability to meet capital requirements over time. As a result, we believe financial markets will continue to reward the strongest and safest banks and penalize the weakest and riskiest banks.
- While we remain cautious on the U.S. housing market, U.S. banks appear to have the resources to manage further housing market weakness.
Uncertainty leads to rising risk aversion and fear, but it can also lead to opportunity. Financial markets are focused on the European sovereign debt crisis, growing political and policy risks and a slowdown in global economic momentum. At the same time, a dark cloud of heightened regulation overhangs the global banking industry while the market awaits the release of the European bank stress test results in mid-July. Naturally, investors have lost some confidence in risk assets and in banks due to a lack of clarity surrounding peripheral Europe, global banking regulations and the world economy.
We believe the probability of a near-term default in Greece has increased due to many factors. Greece has high debt levels and lacks sufficient growth, and is also facing bank deposit outflows, credit tightening, deep austerity, rising social unrest and challenging political realities. Greece lacks fiscal union with the EU despite sharing a currency and monetary union with the rest of Europe; this makes policy coordination a challenge and deep austerity measures difficult to enforce. The country’s inability to devalue its currency or set independent monetary policy means Greece can’t regain competitiveness, grow fast enough to service its high debt burden or inflate it away. Fundamentally, Greece has a solvency problem and not a liquidity issue. Although a Greek default and restructuring is likely just a matter of time given these dynamics, the potential spillover into the overall global economy varies dramatically.
The opportunity in today’s market is to distinguish between the strong and the weak in an uncertain world where most investors tend to go from “risk on” to “risk off” with relatively limited differentiation. We prefer to take risk in areas we believe have high expected risk-adjusted returns and avoid risk in areas with low expected risk-adjusted returns. In addition to Greek and sovereign debt concerns, heightened macro and regulatory uncertainty is putting pressure on global banks, creating opportunities for investors willing to do their homework.
Several members of PIMCO’s global credit team specializing in banks and financials recently traveled with me to New York for on-site due diligence meetings with CEOs, CFOs, treasurers and senior executives at several U.S. banks and specialty financial firms. Our meetings reinforced our conviction that today’s dark clouds may give way to clearer skies, particularly if the economy regains momentum and Greek and European sovereign concerns ease during the second half of this year. This could not only improve most risk assets but also shine sunlight on select banks that appear positioned to benefit from a gradually improving outlook. Despite near-term uncertainty, we believe credit investments in many banks, and in particular U.S. banks, should outperform various investment alternatives in fixed income (e.g., mortgages, municipals, non-financial investment grade corporate bonds, high yield corporate bonds and emerging corporate bonds) over a longer-term secular horizon due to deleveraging and stronger global banking regulations.
Banks in the New Normal
Investors in global banks and financials face two simple realities over the next several years. First, economic growth in the developed world will likely be below trend due to continued deleveraging of stressed public and private sector balance sheets. Second, global banking regulators are likely to make banks and financial institutions safer by requiring more capital and liquidity buffers.
The combination of subpar economic growth and heightened regulation suggest most entities (e.g., the government, consumers and banks) in the developed world will continue deleveraging. Given this environment, which PIMCO has referred to as the New Normal, it is not surprising in the U.S. that bank lending (and demand for loans) has been and remains weak (chart 1). Nevertheless, the secular journey of deleveraging banks’ balance sheets in developed economies, while a headwind for economic growth, should lead to improving credit trends and fundamentals for bondholders.
In regard to regulation, global banks over the next several years will be adopting Basel III standards for capital, and a relatively small group of systemically important financial institutions (SIFIs) will face additional buffers on top of the minimum 7% Tier 1 common capital ratio under Basel III. SIFI buffers could be up to 2.5%, which translates into minimum capital requirements approaching 9.5% for the largest and most interconnected U.S. financial companies. Regulators are giving banks several years to implement these new cushions (and the official date for compliance under Basel III isn’t until 2019). Nevertheless, we believe banks will race to reach higher capital levels: Stronger banks will likely gain market confidence much faster than weaker banks as Basel III requirements, SIFI buffers and deadlines become clear over time.
Global banks can meet higher capital requirements through retained earnings, restricting and limiting dividends and stock buybacks, asset divestitures or equity infusions. Higher capital buffers under Basel III will likely be the main driver of lower return on equity (ROE) as banks are required to build more equity cushion:
Return on Equity = Return on Assets * Assets / Equity
(lower) (roughly stable) (lower under Basel III)
Although the outlook for lower return on equity is challenging for bank equity holders, lower leverage and higher capital requirements are supportive for bondholders. PIMCO has long supported this view (see the December 2008 U.S. Credit Perspectives: “Credit Now, Equities Later”), which is why it is not surprising banks’ equities have underperformed relative to banks’ credit spreads over the past several years (chart 2). Simply put, the New Normal and global banking re-regulation have supported bank and financial investments higher in the capital structure at the expense of investments at the bottom of the capital structure.
While higher capital requirements help make banks safer and – all else being equal – are favorable for creditors, we should remain cognizant of potential negative unintended consequences across the capital structure if regulatory regimes prove overly onerous. In turn, we challenge global regulators to strike a thoughtful balance between preserving the safety and soundness of the financial system while also fostering economic growth.
