Back in black: banks’ long road to recovery

Those who invest in banks will know it can be a rocky road. A reminder of this fact, if it was needed, came as Italy’s latest political storm rattled shares in the sector. However, a look back at the decade since the depths of the financial crisis, when banks seemed doomed, shows just how far they have come.

Ten years ago, many of the world’s banks were essentially bust. The global financial crisis was in full swing and banks were facing their comeuppance for employing huge amounts of leverage to boost returns. This practice worked for a while but such precarious methods never end well.

The crisis exposed banks’ capital buffers as dangerously thin. It effectively wiped out their equity when unfeasibly optimistic asset prices were forced to match reality. Such was the anxiety over the banks’ solvency that UK politicians seriously contemplated putting troops on the street, if banks became unable to dispense cash, to quell an understandably angry population. For many, at that time, the banks were entirely uninvestable.

We have come a long way since, however. European and US banks have been heavily punished, with regulators collecting hundreds of billions of dollars in fines.  The Dodd-Frank Act in the US brought far-reaching reforms, with tighter rules governing the amount and quality of capital required to guard against a future crisis.

Let loose from the noose

Today, this period of punishment is ending. The regulatory environment is more settled, with much stricter oversight. After considerable delay, one of the final planks of global bank governance was agreed in December – the so-called Basel 4 reforms. The new environment necessarily constrains banks’ activities but with the rules of the game largely agreed, the banks can plan accordingly.

Back on track

Banks are now in much better shape. Over the past decade, they have recapitalised to insulate against further crises. With bad debts largely written down or disposed of, their balance sheets are also much cleaner. Admittedly, returns on equity are lower today than they were before the crisis. But that’s because banks must carry more equity and forego the returns of the more speculative parts of their business. Overall, the outlook for cash returns from bank stocks has improved.

The macroeconomic environment is also more favourable. Following the crisis, interest rates were cut to historic lows to prop up the economy and asset prices. Now they are rising again – allowing banks to widen margins on lending. After six rate rises, the US is well on its way. Although the trend is upwards, it is likely that the rest of the world will be slower to hike than the US. That said, Europe could be next and even the Bank of Japan may look at moving away from negative interest rates. Rates remain low in a historical context but banks are not sitting on their hands, with most focusing on cost-cutting to improve profitability.

The political backdrop is helping too. Populist governments are willing to spend money, which should be good for banks’ profits. In the US, President Trump has cut taxes heavily. This should not only fatten bank profits but also put more money into consumers’ pockets, which in turn helps the banks. Of course, populism has its downsides too. Stockmarkets hate the uncertainty that comes with maverick leaders while unrestrained public spending, though popular with some, could derail economic stability once more.

Room for recovery

In the US, much of this has been acknowledged in share prices. After rallying in anticipation of the spoils of a Trump presidency, US bank shares are close to their pre-crisis highs. But not all banks have recovered as much. The MSCI Europe Banks Index is still more than 60% below its 2007 pinnacle, potentially a sizeable opportunity. However, history teaches us there could be many ups and downs along the way.

Ugly ducklings

So where do we see opportunities in the banking sector? Well, one is perhaps the most infamous name of the financial crisis. After expanding aggressively at the peak of the market, RBS became the poster child for banking failure. But the company is now on its way to putting the crisis behind it. RBS has succeeded in deleveraging its balance sheet and refocusing on its core UK market and is close to settling one of its last major fines. That should clear the way for the company to restart dividends. Its latest results showed a tripling of profits, suggesting real progress. We categorise the company as an ‘ugly duckling’ – a stock whose transformation could take the market by surprise.

Another ‘ugly duckling’ is Sumitomo Mitsui Financial Group. Japan’s banks went through their own crisis in the 1990s, but are in much better shape today. They remain out of favour with investors because of Japan’s negative interest rates. But with change afoot in Japan, any improvement in the economy is likely to benefit its cheaply valued banks.

Finally, Citizens Financial is a US bank that regained independence when RBS retreated to the UK. Given RBS’s numerous preoccupations closer to home, its US operation was not efficiently run. The spin-off created an opportunity to run the business more effectively and Citizens has performed well, as it demonstrated its ability to steadily improve its profitability.

*As at 8 May 2018

Please remember that past performance may not be repeated and is not a guide for future performance. The value of shares and the income from them can go down as well as up as a result of market and currency fluctuations. You may not get back the amount you invest.

Please note that SIT Savings Ltd is not authorised to provide advice to individual investors and nothing in this promotion should be considered to be or relied upon as constituting investment advice. If you are unsure about the suitability of an investment, you should contact your financial advisor.