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Rallying value

Mark Thomas
PA Consulting Group 
Financial World
1 February 2008

Mark Thomas plots a path for banks seeking to emerge from the sector’s turmoil and rebuild investor confidence

The malaise in the banking sector needs to be put into context. If one looks at the creation of  shareholder value in the last decade, there has been a dramatic improvement in the ratio of market value to book value (MV/BV). As diagram 1 shows [see PDF file], most European banks enjoyed an increase in MV/BV between 1994 and 2006. Indeed the average increase is around two-thirds.

Across this 12-year period there are some strong performers that have seen their MV/BV almost double to between 2 and 3 from 1 to 1.5: examples are BBVA, Banco BPI, Banco Popular Español and Bank of Ireland.

However, this trend reversed dramatically during 2007. Diagram 2 [see PDF file] compares the MV/BV ratio for European banks at the beginning of 2007 on the horizontal axis, with the level at the beginning of 2008 on the vertical axis.

The fact that there have been falls is no surprise – the press has been bursting with tales of banking woe following the credit squeeze. But what is intriguing is that although virtually all banks have been affected, some have been hit much harder than others. Strong performers such as BCP, Bankinter, Banco BPI, Lloyds TSB and Banco Popular Español have held up relatively well, with the MV/BV at the beginning of 2008 in excess of 75 per cent of that at the start of 2007. In contrast, institutions such as HBOS and Crédit Agricole were at 60 per cent or less from their weaker starting positions.

Those that are heavily reliant on the UK housing market (e.g. Bradford & Bingley) fared even worse, with a decline of around 50 per cent. Alliance & Leicester suffered the same fate until its shares were recently bolstered by takeover speculation. It is also evident that two of the three bidders for ABN Amro (Royal Bank of Scotland and Fortis) had been marked down by the market whereas Banco Santander proved resilient.

But this catalogue of sorrows raises more questions than it answers, namely:

  • should we expect further falls or has the market taken full account of bad news?
  • some institutions have fared far worse than others but is this shift in relative ranking based on objective assessment or sentiment?
  • what will drive an upward revaluation in bank shares and which institutions are likely to lead a rally?

These questions are relevant because neither past success nor recent difficulties may be a guide to future prospects.

The environment in which banks are operating has undergone change and it is likely that those institutions that prosper will pursue business models that differ from those that found favour in the past. This will reflect both different opportunities to capture value and an increased investor sensitivity to risk.

It is scarcely surprising that bank share prices have fallen sharply because:

  • market opportunities are fewer and there is less scope to do business;
  • margins have been squeezed, reflecting the higher cost of funds and fixed costs being spread less thinly;
  • investors’ required rate of return (RROR) has increased, reflecting both an increase in the risk-free rate and in the required risk premium, as bad news is priced in by the market.

We have modelled in some detail the relative importance of the factors determining MV/BV ratios: the required rate of return; the return on equity (ROE); and the prospective growth rate.

The MV/BV ratio falls when the RROR increases, the ROE shrinks or the prospective growth rate falls (as long as the ROE exceeds the RROR).

Specifically, the ROE in the UK, Ireland, Spain and the Nordic countries was about 20 per cent in 2006 (and 13-15 per cent in Germany, France and Italy). With a required rate of 9 per cent (comprising a risk-free rate of 5 per cent and a risk premium of 4 per cent) and a prospective growth rate of 4 per cent, this gives an MB/BV ratio of 3.2.

But with a reduction in ROE to 15.5 per cent and an increase in the RROR to 11 per cent (comprising a risk-free rate of 6 per cent and a risk premium of 5 per cent) and a prospective growth rate of only 2 per cent, the MV/BV ratio drops to 1.5.

Institutions that do not respond to these environmental changes can expect falls of this magnitude.

Enlightened ones will bear down on the rate of return required by investors. It is perhaps surprising that for a typical bank, with an ROE of 17 per cent and cost of equity of 10 per cent, there is some 60 per cent more leverage in a given percentage reduction in the RROR than in the same percentage increase in the ROE.

The largest component of the RROR is obviously the risk-free rate and the institutions have no influence over this. They are environment takers in this respect. But they can influence the required risk premium which is driven by the level of undiversifiable risk. In part this will entail avoiding some risky business, including that judged to be far more risky today than it was before the crisis.

This is a case of avoiding risk that can be measured. It may entail the divestment of businesses with volatile income streams, which increase non-diversifiable risk. The upshot of this is an expansion of the role of risk management beyond the focus on specific risk.

Bearing down on the risk premium is also a question of managing perceptions. The expected risk level for prospective investors may be quite different from that which is objectively measured. When it is higher there is a powerful case for investor education, which may require better disclosure – more information and more timely release. When the perception is lower than the real risk level it is only time before the truth will become apparent. But it is inappropriate to wait; better to manage risk down or make absolutely sure that it is not mispriced. The market will soon punish those who are complacent.

What does this mean in effect? Quite simply, investors will not turn a blind eye to risk and risk management practices. They will no longer give large and complex institutions the benefit of the doubt.

On the contrary – when they are not sure they will be inclined to expect the worst. And institutions that fail to capture and manage risk data with the appropriate transparency will garner a punitive risk premium. Transparency, predictability and resilience will be rewarded by investors bruised by the recent price slide.

Ensuring that the ROE exceeds the RROR also of course entails managing the ROE itself – the second most important driver of MV/BV. This requires pulling on the traditional financial levers, namely:

  • growing material revenue streams, for instance through segment selection and emphasis on distribution channels;
  • containing the cost base;
  • leveraging capital, taking account of the challenges and opportunities resulting from Basel 2 without engaging in the financial engineering that gave rise to the liquidity crisis.

But while these activities are important, enlightened institutions will still start by trying to bear down on the required rate of return – it is a question of both mathematics and pragmatism. The pay-off from doing so is rapid and universal whereas initiatives to enhance ROE will take up significant time for only a modest impact.

Banks need to undertake a reorientation programme in order to win investor support.

The first strand entails bolstering risk management, as well as actively rebalancing the portfolio – the second bolstering ROE. When measures have been successfully undertaken in each of these areas the market may be more conducive to a drive for growth (which also of course increases MV/BV, as long as ROE exceeds the RROR).

Our work confirms that it is critical to decide both what to do and the right sequence of actions. Tight programme management will identify milestones and track achievement within a shareholder value framework.

As individual banks strive to rebuild investor confidence some will be more equal to the task than others. Many of those that are particularly successful will become predators.

The prey will be those institutions that have been unable to dispel investor scepticism, whatever its root cause. And investment bankers, driven by self-interest in the 2008 bonus year, will go to extraordinary lengths to lubricate the market for retail bank assets.

This is something that retail banks, irrespective of whether they see themselves as predators or prey, will be debating in board meetings. The non-executive directors should insist upon it.

Mark Thomas is a member of PA Consulting’s management group. Mark is author of The Complete CEO, advises organisations on business strategy.

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