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The rise of Mark Carney

MM 10Dec Rise of Carney

The appointment of Mark Carney as the new governor of the Bank of England has been welcomed by everybody – with the possible exception of investors who have UK bank equities in their portfolio. Shares of lenders listed in London stumbled as soon as the Government announced that the president of the Canadian central bank will take over from Mervyn King in July next year.

The immediate negative reaction took place even though few people seem to disagree with chancellor George Osborne’s definition of Carney as the “outstanding central banker of his generation.” And that is because his selection indicates that tighter regulation, which banks fear will drown them under a flood of new capital requirements, is definitely coming along.

Which means, in other words, that we are not going back to the good old days before Lehman Brothers, when dividends were sky-high, investors were happy and bankers even more.

“The BoE has quite a lot of challenges in the years ahead, so bringing the most experienced, most respected manager that they could was an excellent idea,” says Erin Davis, a senior analyst at Morningstar. “But if there was any hope that it was all a lot of tough talk only and that things would gradually stay like they are, there is no reason for such a hope right now.”

Carney has built his reputation in Canada with a conservative approach to banking regulation that helped to keep the country’s economy humming even during the worst stretches of the global crisis. He has been not afraid to voice support for the regulatory onslaught that is being drafted by authorities in several countries, and has even claimed to Canada the honours of pioneering some of them. The result has been that Canadian banks failed to deliver the rocket-like performances of their UK rivals during the boom years, especially because they were prevented from excessively leveraging their balance sheets.

On the other hand, while during the financial crisis “many financial emperors around the world were seen to have no clothes,” as Carney said in a speech in November, Canadian lenders, “were comparatively draped in full winter regalia”.

In the same speech, Carney boasted that rules like the so-called leverage ratio, which limits the ability of banks to borrow money, were exported from Canada to global banking regulation standards. Based on his words, therefore, there are few if any reasons to believe that Carney will relent from the hard line towards banks that current BoE boss King has embraced since the crisis started.

The experience of Canada, however, indicates that the conservative approach adopted by Carney might not necessarily mean bad news for bank investors. Canadian bank stocks have been star performers in the sector, benefiting from the prolonged good moment of the commodity exports-based economy where they operate. The Royal Bank of Canada in fact reported by the end of October the biggest ever profits posted by any Canadian company. Canadian banks enjoy a reputation of being solid delivers of dividends and continue to be prized by investors even though their valuations are well above those of global peers.

“In Canada, banks have done phenomenally well,” Davis says. “Their return on equity has been around 18 per cent on average.” Banks in Canada are allowed to charge steep prices for some products, she said, but on the other hand they are kept under a tight leash by regulators. “They are expected to be conservatively managed, and that is one of the reasons why they have been doing so well.”

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She notes that Canada’s banking sector is to some extent similar to the UK’s, with a few banks concentrating most of the market. A significant difference, though, is that their investment banking operations are much less relevant to their overall results than in the case of Barclays today or The Royal Bank of Scotland before the crisis.

Carney has expressed strong views against the existence of banks deemed too big to fail and the implicit guarantees that they enjoy from governments – a message that is unlikely to have been ignored by shareholders of RBS and Lloyds TSB, for example. He has advocated that regulation should make sure that banks could go bust if they take excessive risks, and has praised those financial firms that have already been able to shed non-core activities and to reduce their leveraging and exposure to risks, the kind of outcome that the controversial ring-fencing rules currently discussed in London and Brussels are expected to bring about.

In his view, new regulation that has been drafted by the likes of the Financial Stability Board, which Carney heads, will make the banking system look less risky for investors in the long run. UBS, in fact, has improved its recommendation on RBS stocks because it believes that the appointment of Carney will reduce uncertainties about the UK banking system.

But that should not hide the fact that the UK banks which will soon become Carney’s responsibility will have to swim through a sea of challenges in the short run. For investors, it is important to understand what it is at stake and to what extent it might be worth taking a look at such stocks. Some have argued that the UK’s troubled lenders might even be in the verge of becoming pretty interesting investment propositions.

Tim Friebertshaeuser, a portfolio manager, global financials, at DWS, says: “UK banks focussed on the domestic market are looking very cheap today, as they are trading at about 0.6 times tangible book value.”

The low prices are a sign that investors have acknowledged that the sector will continue to struggle for quite a while. Many factors contribute to the perception. One of them is the underwhelming performance of the UK economy, which for some analysts could be entering the latest stage of a triple-dip recession. Banks have been both victims and contributors to this state of affairs. Their revenues have suffered with the lack of activity in sectors like the housing market, but at the same time many accuse them of keeping the brakes on the economy by not opening up the taps of credit to individuals and companies.

They have an image problem too. UK banks have been accused of making money by selling complex derivative products to small investors without proper guidance and have been at the center of the scandal about the alleged manipulation of the Libor rate. The names of HSBC and Standard Chartered have been mentioned in scandals abroad, helping to drag more mud on the top of the City’s reputation. Bank-bashing has even become a popular choice among officials looking for an easy headline.

Andy Haldane, an executive director at the BoE, has told the BBC that the loss of income ad outputs caused by the crisis, in which banks have played a big part, has been as bad as a ‘world war’.

However the biggest spectre hovering on the sector is likely to be the new set of rules to which banks will have to adapt themselves in the near future. Nomura, a Japanese bank, pointed out in a report that forthcoming capital requirements, which will be much higher than those that applied before the crisis, indicate that banks focussed on the UK market will be unlikely to pay dividends for shareholders for a long time yet. It estimates that banks will only be able to fully comply the Basel III capital requirements in around 2015, which should prevent tangible returns to be reported until that date. In this scenario, any dividends could only start being paid by 2016.

The capital ratios that they will have to meet once Basel III and other rules come to the fore also mean that they will have to lower profits and to keep on restructuring their businesses. And that is an assumption based on the numbers that have been made publicly available by banks. According to the BoE, a much higher hole might actually have to be covered in bank’s balance sheets in order to comply with Basel III.

In its latest Financial Stability Report, the central bank said that progress by banks in raising capital has slowed recently, and that the confidence of investors in them remains low. The reason could be that markets harbour doubts about how closely the stated levels of capital reported by banks reflect their real needs, when it comes to being able to meet losses in the future. “Information from supervisory

intelligence and banks’ own public disclosures suggest that expected losses on loans, including those subject to forbearance, are in some cases greater than current provisions and regulatory capital deductions for UK banks’ expected losses,” the report says.

In the document, the BoE also noted that banks have in the past published insufficient estimations about costs created by the need to fix conducts like the mis-sale of payment protection insurance, resulting in lower capital provisions than it would be desired. With so many complaints about the conduct of banks reaching the authorities in 2012, this could become a problem in the future. The BoE also warned that the capital positions of banks could be overstated because methods currently employed to weight risks are complex and opaque. “In combination, these factors would imply that UK banks’ capital buffers, available to cushion losses and maintain the supply of credit following realisation of a stress scenario, are not as great as headline regulatory capital ratios imply,” the BoE stated.

As a result, the central bank has recommended that the FSA keeps a close eye on UK banks to make sure that they will take the necessary steps to meet forthcoming capital requirements. That means, in practice, that they will have to either raise capital or to restructure their businesses to adapt the weighting of their risks to their capital buffers. Not only that, but they also need to ensure everybody that such dramatic steps are taken without hindering the recovery of lending to the overall economy. As the BoE has itself noted that profitability of banks has been subdued of late, doing all this things at the same time in the current economic environment looks like a daunting task.

The most straight-forward alternative to raise capital levels is to issue new equity, which is also, of course, one that current shareholders are not willing to contemplate. But there are other ways by which banks can put the worries of regulators to rest, and the process is already well under way, according to Friebertshaeuser.

‘Many financial emperors around the world were seen to have no clothes’

He says: “In the past five years, UK banks have dramatically deleveraged,” he said. “They have increased liquidity and increased their capital levels. Regulation will be drastic, but banks will be able to deal with it. They will reallocate capital towards businesses where requirements will be less demanding.”

But questions still linger on how much has been done, and how eager banks are in fact to reform their ways. Nomura says that getting rid of non-core assets, something that both regulators like Carney and shareholders have been demanding, continues to be a big challenge for UK banks. The company’s analysts have estimated that between 16 and 18 per cent of the capital held by Lloyds and RBS, for instance, will remain tied to non-core assets for a good while.

“We suspect that the rump left in these divisions will have long maturities or will be difficult to sell assets and may be a drag on group ROEs for a few more years,” Nomura states in the report.

Davis points out that some banks have not really accepted yet to what extent they will have to curtail their riskiest activities. Investors, however, have been putting pressure on them to move in that direction. RBS, on the one hand, has already slashed its investment banking operations, answering to the urgings of the government, which rescued the bank during the crisis and still is its main shareholder.

Outside the UK, Switzerland’s UBS has been a recent example of universal bank that has announced restructuring plans to reduce its reliance on investment banking and focus on the retail market. Some shareholders want Barclays to follow the lead, even though the sponsors of the English Premier League rely on its investment banking arm for about half its profits, according to Davis.

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Barclays is scheduled to announce restructuring plans in February. Nomura says that the bank’s operations in Southern Europe, once a source for growth but now an ingredient of exposure to the Eurozone crisis, will be classified as non-core when the bank takes a new shape. But BarCap, the investment banking unit, remain, in the analysts views, the “elephant in the room” for the bank. Nomura sees Barclays cutting down the activities of BarCap so that it generates a 15 per cent reduction of the unit’s risk weighted assets, which would mean that capital provisions needed to meet the risks taken by BarCap would be lower in the future.

But the knife could hit BarCap in a more dramatic way if external pressure continues to build up, especially after the precedent set by UBS. Plans to separate retail and investment arms of banks, known as ring-fencing, that are being discussed at the UK and European levels could have a say on it too, if they finally become reality.

The case for UK banks is therefore not an easy one to make, although there are other nuances that need to be considered. In fact, two lenders listed in London have been among the darlings of investors in financial stocks of late. HSBC and Standard Chartered are nominally UK banks, and HSBC even has a strong domestic operation. But in both cases most of their revenues derive from operations in emerging markets.

The exposure of HSBC and Standard Chartered to the fast growing economies of Asia, where banking still has a long way to go, is particularly enticing for investors. But that also means that their valuations are not as attractive as their purely UK peers. Davis notes that both stocks are currently fairly valued by investors, which does make them as cheap as the shares of other banks. But analysts say that the naming of both banks in scandals focussed in their US and Mexican operations have hit somewhat the price of their stocks, creating an opportunity for investors to get in companies that are well regarded by experts. Banco Santander, the Spanish bank that has a large high street operation in the UK thanks to the acquisition of Abbey National, is also often mentioned as a prospect for investors seeking an emerging markets play, mostly thanks to its exposure to Latin America.

Even if they do not count with the Asian or Latin American factors, the other banks could offer some value as part of a portfolio of stocks, according to Davis, thanks to their current valuations. Friebertshaeuser, for his part, stresses that, if some factors come into line, the sector could actually prove to be quite interesting.

The first factor is the eurozone crisis. Both Lloyds and RBS have considerable exposure the embattled Irish market, even though they have been reducing their presence in the Emerald Isle. Barclays has operations in Spain, Italy, Greece and Portugal. The situation in the eurozone appears to be in the mend, but politicians have repeatedly proved that no progress can be taken for granted in the region. “They need better news from the Eurozone,” Friebertshaeuser says.

The second factor is that funding markets continue to recover, making it easier for banks to raise money for their daily operations. “We have seen better risk spreads in the interbank market, so the funding costs for UK banks should be dropping next year, which will be good for their interest margins,” the DWS fund manager adds. But again, any new doubts about the health of European banks or other events that shake jittery markets could change this scenario.

Finally, Friebertshaeuser says banks need the regulation to be imposed on them to be reasonable. But that could not be the case if you believe the complaints that bankers have voiced of late. If the sector has a good break in all these three elements, banking stocks will benefit considerably. “Shares of the three UK-focused banks should recover in the future,” Friebertshaeuser says. “Maybe not to the levels of HSBC and Standard Chartered, but the equity market is too harsh a valuation on them today.”

In the view of Nomura, however, UK banks are in for a long, bumpy road. The firms’ analysts have stressed, for instance, that non-performing loans in the UK remain high at 8 per cent, even though the ratio appears to have stabilised of late. This number is lower than similar measurements of risk in Italy, double the ratio in French and four times higher than in Sweden. In fact, Nomura has qualified UK-focused banks as “value traps” and believes that investors can find better value elsewhere. And this is despite the fact that valuations of European banks, at an average of 0.9 tangible book value, are higher than in the UK.

Nomura likes lenders in Scandinavia and Switzerland, but they can hardly be characterised as bargains at current prices. It says that French companies have low multiples that do not reflect the improvements that they have made to their balance sheets, while France’s economy is in better shape than people believe. It also says that Italian banks should be among the main beneficiaries from improvements in the economic and debt outlook in the eurozone, while their valuations are very low at the moment.

Investors who want to get exposed to financials but are skeptical of stocks could also take a look at banks’ debt, Nomura argues, as their bonds have generally outperformed equities. New issues of bank debt should hit the market soon as they offer more attractive options to raise capital levels than share offerings. And the example of Japan shows that bank debt can outperform equities for a long time, the analysts pointed out.

In any case, investors should be ready for a new world when it comes to banking securities, especially if they still bore any hopes that pre-crisis performances could one day make a come back. “We are moving towards a normalisation phase in a low growth, low interest rates environment,” Friebertshaeuser says. “But even then, if it is possible to buy into banks at 0.6 times tangible book value, while their balance sheets look ok, it is a valuable proposition.”


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