Emotion and the Bank Sector

Currently, the troubled banking sector seems to defy conventional analysis. The impact of new regulations, combined with scandals and regulatory fines, seems impossible to calculate. Bank ratings across Europe – and in the UK in particular – show that most investors have given up trying to value bank shares. Many conclude that there are easier ways to make money than betting on how the banking crisis ends up. But, the case can be made for buying banks. The key is to look at the psychology of those who control banks’ destiny – the politicians.

The negatives are easy to see. Market commentators and regulators alike are encouraging politicians into a tougher stance on banks. It is not just a matter of punishing the sector for its behaviour up to 2008, but a determination to avoid any repetition of those mistakes. Many think that a sound bank sector in future – to prevent any more taxpayer losses – should involve much higher reserves.

Banks are essential to lending and financing credit markets, but society has limited risk tolerance. Banks with leverage that reached 60x in 2008, have typically now at least halved the ratio. Leverage peaked in the crisis at levels that left a less than 2% margin of error for some banks. But, prudent banking in future might involve leverage of no more than, say, 10x. Regulators around Europe would be much more comfortable with that structure.

But, this seems unlikely to happen any time soon. Politicians may not emotionally feel like appeasing the public and deflecting criticism from their opposition by flogging the sector a bit more. But, hitting banks simply does not look like the way to get re-elected. Creating economic growth, with healthy bank lending, is what matters.

Although a few European banks have recently raised equity – generally on distressed terms – such finance is not currently open to the partly nationalised UK banks. Nor is their profitability likely to build up balance sheets in the near term. Different solutions are needed.

Already, the severe impact of deleveraging, as banks cut back their loan books, is threatening growth. If the UK Government needs any further warning on how bad this could get, France is showing just how rapidly an economy can shrink when deleveraging really bites. That is not an experiment that Britain needs.

And, when banks are being encouraged to shrink, telling them to lend does not work. Banks can be given gross lending targets, but net lending falls as loans are quietly called in. That leaves politicians with just one route to economic growth and re-election – they simply have to reduce the pressures on banks. Cutting the sector some slack seems to be the way in which the conflicting challenges of regulation and growth are resolved.

There are signs that politicians are resisting calls from regulators and central banks to raise the bar even further for banks. For banks with assets to sell – such as RBS with its Citizens Bank and Lloyds’ interest in St James’ Place – improving their balance sheet is easier. We can expect more discussion about flotations and disposals. So, despite the high profile fines and political rhetoric, life may get easier for banks, with less appetite for rapid de-leveraging.

Politicians might recognise what eventually has to be done about the sector – but much of that will be years in the future. Getting banks to lend again is what matters. Our leaders will set emotion aside, and focus rationally on their own election prospects. That means banks, at current valuations, are attractive despite the uncertainties around.

Full disclosure : long RBS, Lloyds
This article is for informational purposes only. The opinions in this article are the author’s own. The information presented in this article has been obtained from sources believed by the author to be reliable, however, he makes no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Colin McLean may have an investment in any of the companies mentioned in this article.