Bank shareholders are having a hard time. Squeezed margins and weighty regulation have dampened profit and potential for traditional banks around the globe. For many banks, the absolute and relative decline in their share prices has followed inexorably. In contrast to buoyant stock-markets more generally, the index of European bank shares for example, recently touched a 30-year low.
Some argue that bank shares are now ‘cheap’ and represent an attractive investment opportunity. In many cases trading below the balance sheet valuation of their equity, they argue that even a modest improvement in business performance would spark a sharp rebound in bank share prices. They may well be right. But before committing hard-earned savings in the hope of such returns a deeper ponder is advisable.
Banks are different. They are structurally vulnerable to crisis. We can’t know when or where the next banking crisis will occur, but we do know that with their current structure there will be one.
The then Governor of the Bank of England, Sir Mervyn King, summarised this memorably at a speech in New York in 2010, ‘Banking – from Bagehot to Basel and Back Again’:
‘Banking crises are endemic to the market economy that has evolved since the Industrial Revolution. The words ‘banking’ and ‘crisis’ are natural bedfellows. If love and marriage go together like a horse and carriage, then banking and crisis go together like Oxford and the Isis, intertwined for as long as anyone can remember.’
The fundamental difference between banks and other businesses is their capital structure. In comparison to almost any other business, banks are overwhelmingly funded by debt. This has not always been the case, but it has become their defining feature over the past few decades.
For example, although unchanged for centuries, in less than four decades in the run-up to the global financial crisis bank assets in the UK as a % of GDP – overwhelmingly funded by debt to depositors, bondholders and each other – exploded by a factor greater than five:
UK Banking Assets as % of GDP
The following comments by King from the same speech in 2010 capture this reality well:
‘The size of the balance sheet (of banks) is no longer limited by the scale of opportunities to lend to companies or individuals in the real economy. So-called ‘financial engineering’ allows banks to manufacture additional assets without limit.’
‘While banks’ balance sheets have exploded, so have the risks associated with those balance sheets. Capital ratios have declined and leverage has risen. Immediately prior to the crisis, leverage in the banking system of the industrialised world had increased to astronomical levels. Simple leverage ratios of close to 50 or more could be found in the US, UK, and the continent of Europe.’
‘The size, concentration and riskiness of banks have increased in an extraordinary fashion and would be unrecognisable to Bagehot.’
Endogenous Money/Asset/Liability Creation
‘Money: Whence it came, Where it went’, J.K Galbraith, 1975:
‘The process by which banks create money is so simple that it repels the mind.’
To the wry amusement of Galbraith, the money or asset/liability creation process is scarily simple. Borrower looks for loan. Bank grants loan. Loan creates deposit. Borrower spends deposit. Bank pockets the difference between interest received on its loans (assets) and interest paid on its deposits (liabilities). Bank has a compelling incentive to repeat this process as often and in as big a size as possible. Bank faces no effective constraint in its compunction to exploit this compelling incentive. Central bank is a largely passive accommodator of this money creation power of the private banking system.
It is hardly surprising that bank assets and liabilities i.e. their balance sheets have exploded since Nixon cut money free in 1971.
The fundamental point is that private banks create most of our money (and their assets/liabilities) out of thin air. The small amount of paper printed or coin minted is all but irrelevant.
Despite the widespread commitment to reform in the wake of the financial crisis and the extensive measures put in place since, private banking and its money/asset/liability creation capacity remains fundamentally unchanged:
- Banks still have a compelling incentive to expand their balance sheets.
- Bank assets are still supported by a relatively small sliver of equity.
- Banks still run the risk of a dangerous mis-match between their assets and their debts.
- Banks still rely on the backing of central banks and ultimately governments.
There is little reason to believe that the long association between the words ‘banking’ and ‘crisis’ is materially looser today than before the crisis.
As summarised recently in the Financial Times by Martin Wolf:
‘Today, banks are less leveraged and better supervised than before the crisis. In the UK retail banking is also ringfenced. Yet, the banks are leveraged at about 20 to 1: if the value of their assets falls by 5% or more, such a bank becomes insolvent.’
The key message for investors is that the risk borne by equity investors in a bank is of a fundamentally different order than that borne in almost any other business.
That is not to say that there won’t be times when buying bank shares will prove profitable. Nor is it to say that now isn’t one of those times. The message is simply that banks are different and, as investors, we need to treat them differently.