The writer is a Managing Partner and Head of Research at Axiom Alternative Investments
Large European banks have excess capital of more than 500 billion euros. For listed banks, this is 43 percent of their market capitalization.
In a world where banks were free to reward shareholders as they pleased, while keeping capital above minimum requirements, they could pay out 43 percent of their entire market value as a special distribution. This is an amazing number. However, European banks trade at an average valuation of 0.6 times their book value.
This is not new: banks have been trading at low valuations for a long time. For years, negative rates were mostly to blame, which hurt profitability. Repercussions of monetary policies around the world changed that, and banks’ profitability expectations rose sharply.
What is happening? Back in the mid-2010s, there was an old joke about banks’ surplus capital: as a shareholder, you’d be foolish to believe it belonged to you, because it belonged to governments. They’ll take it through fines for past misconduct or new capital requirements. But that, too, is a story from the past: Basel IV’s renewal of banking regulations is almost finished, and global litigation is winding down fast – except perhaps for a few banks.
Have governments found a new way to “take” banks’ surplus capital? There is a theory gaining traction that ours is very similar to the 1970s with deflation, recessions, energy shocks, etc., and that, as in the 1970s, this will lead to excessive government control of banks and credit – something that will ultimately hurt shareholders.
There are indeed some alarming signs, I will describe four of them. At the start of the Covid-19 crisis, the European Central Bank imposed a blanket ban on dividend payments, no matter how strong the bank’s balance sheet was. This was justified not only on solvency grounds but also because the banks “needed to continue financing the economy”. The underlying assumption – banks should act in the public interest, not in their own interest – seems very noble, but it is also not usually associated with private companies. Banks should usually be free to contract or expand their balance sheet depending on their perceptions of the economic environment.
Additionally, during the pandemic, a large percentage of new loans have been guaranteed by governments. In theory, the role of the bank in the economy is to allocate capital and assess risk. When they lend hundreds of billions with government guarantees, they are effectively diverting a large portion of their balance sheet to quasi-government entities.
The emergence of environmental, social and governance factors is also leading to an increase in the direction of bank lending. This works in more subtle ways, with complex regulatory disclosures and veiled threats of higher capital requirements, but the conclusion is the same: bank lending is directed at some specific sectors, based on considerations that are not entirely financial.
It is very easy to understand the urgency of financing the low-carbon energy transition, but discussions about classifying or excluding some sectors such as weapons are much more difficult. Bank shareholders may be under the impression that they are required to do the work of legislators who are afraid to make decisions themselves.
Finally, recent tax developments have reinforced the idea that bank money is government money: after years of low returns, some countries (such as Spain and the Czech Republic) have decided to introduce a “sudden bank tax” to offset the impact of new monetary policies.
The fiscal impact remains modest, but investors fear generalization and continuity, especially as central banks face large losses on their QE bond-buying programs as interest rates rise – losses that will pass on to governments. The temptation to offset these would be enormous.
However, I think we should not exaggerate these trends. Most lending remains unrestricted. Moreover, Covid was a truly unprecedented event and the argument that “there will always be another crisis to justify government intervention” is a bit weak.
But this should be a warning. A world of low interest rates has brought about misallocation of capital. It would be a shame to replace one misallocation with another. From 1972 to 1985, France had a quantitative credit control system. A few years after it ended, the country faced its “worst banking crisis since World War II,” according to the Senate, with part of the damage coming from 13 years of credit control. We must not repeat these mistakes: strong banks make for a strong economy.
Axiom is an investor in bank stocks and bonds