When I gave a talk last week about bank-merger policy, I was asked an important question: if I’m right about the franchise-value challenges facing most U.S. banks, then why is banking here doing so much better than in other advanced, market-oriented nations? The answer in part is that, in a pond full of ugly ducklings, a scrawny mallard with just a few more feathers looks a lot better. But, it’s more complicated than that. The reasons why make it clear that, if bank-merger policy remains implacably set against economies of scale and scope, then only a very few, very big birds and more than a few nonbirds will own the waters.
As in any comparative analysis, the first step to judging U.S. banks versus those in other nations is to define which banks are being compared. Most other nations have very few, very big banks often considered national-champion charters dedicated as much to supporting their sovereign governments as to placating shareholders. As our recent merger-policy paper details, national champions are insulated from market discipline because they are almost always expressly too big to fail. Credit Suisse was an exception to this rule, but only because it failed so fast and Switzerland was so unready for resolution that it could do nothing more than fold one national champion into another, UBS.
For all the talk of TBTF banks in the U.S. and the benefits the very biggest enjoy during flight-to-safety situations, none are yet a national champion, and a good thing too. The market discipline applied to the very largest U.S. banks may be imperfect, but it’s a lot more stringent than that applicable in many other advanced nations. It thus forces better return on investment than requisite as banks are de facto utilities.
Further, that the very biggest U.S. banks do better than many foreign ones when it comes to ROI doesn’t mean that they do well when it comes to ROI compared to the nonbanks in which investors can buy shares just as readily as banks big and small. A recent McKinsey study finds that only fourteen percent of global banks – i.e., the very biggest – have ROIs sufficient to ensure long-term viability compared to 62 percent of nonbank publicly-traded firms.
The study breaks this down by nation when it looks at price-to-book and price-to-earnings ratios. Here, all too many U.S. banks have trouble keeping their heads above water even if more of them do better than banks in other nations. The weakness in price-to-earnings ratios is also worrisome given the record highs in U.S. equity markets, but this hasn’t lifted banking’s boats anywhere near as high as that of companies competing with banks or, regardless of what else they do, offering investors the better prospects investors rightly seek.
The harder banks compete for shareholders, the higher the cost of capital and the greater the hit to long-term viability. Banks that don’t make enough money to gratify investors are banks that aren’t banks very much longer. Weaker banks can be absorbed by stronger ones if acquirers can and should demonstrate that they have sufficient resilience, a good community-service record, and a demonstrable ability to ensure effective operational integration. But, if bank-merger policy blocks sound deals, then weaker banks get weaker, taxpayer risk grows, and systemic risk is likely to rise along with macroeconomic hazard.
Market realities – not regulatory theories – determine the fate of the banks investors choose to bypass. Regulatory-capital ratios are vital to judge safety and soundness for prudential purposes, but market capitalization – price to book – is essential to long-term franchise value. The passive investing feared so much by Rohit Chopra may actually be a safety net for regional banks because index investing forces fund sponsors to hold bank shares even if active investors eschew them.
I was also asked last week about how pending regulatory efforts to limit third-party vendors affect the long-term strategic outlook. I said then and the McKinsey study reinforces the fact that banks have turned to third-party vendors not because they want to give away vital intermediation or technology functions, but because they have to.
Smaller banks have sold their souls to fintechs not because they are willfully putting customers at risk, but because they don’t have the luxury of worrying about this since they can’t gather enough deposits or make enough loans to earn viable ROIs without these “partnerships.”
Regulators are rightly reining these in and will also soon turn to core service providers and others performing essential infrastructure functions many banks can no longer manage on their own. Curtailing risky third-party relationships will make banking safer, but it also makes it even harder for banks to earn the economies of scale that will surely strain all but the biggest banks.
None of this is happening at a good time. As rates fall, loan growth remains weak, unrealized losses stay stubbornly high, and regulatory pressures continue, bank profitability will be under acute stress even if nonbanks lay off key product sectors, which they won’t. Weak banks that can’t merge wither and die. This might be fine if they were ordinary companies, but they’re not – they’re banks and thus carry FDIC insurance, take out FHLB advances, use FRB facilities, and otherwise rely on taxpayer largesse. The price for misguided merger policy is thus higher than in many other sectors, warranting rapid remedy before market realities again surprise regulators and bail-outs begin all over again.