Dan O’Keefe of Artisan Partners argues that, following a comprehensive makeover, banks are looking increasingly attractive.
Since the crisis, financial regulators have enjoyed more power than ever. In some ways, they have acted as lightning conductors for public anger over bankers’ misdemeanours, harnessing that frustration to deliver a far tighter regulatory regime.
There have been two important results for investors. The first is that the capital profile of major banks has been transformed, with reserve ratios radically increased and leverage pushed far below previous levels. The second result is arguably just as important; namely that potential new entrants have been put off, leaving existing players in a strong position, particularly the larger banks.
“Banks are essential to the functioning of the economy – in a way, they are a utility,” says Dan O’Keefe of Artisan Partners, co-manager of the Global Managed fund. “And banks have actually gained competitive advantage over the past ten years.”
“The regulatory costs and scrutiny have become barriers to entry – particularly the costs. Banking is a scaled business like all commodity businesses, and the bigger you are, the more cheaply you can provide the service, and the higher the margins,” says O’Keefe.
What happened to banks before the crisis is all too well-known. Leverage was increased to maximise returns, aggressive assumptions about lending were made, loan underwriting became sloppy, and regulators took their eye off the ball. In fact, regulators did worse than that, says O’Keefe. They actually contributed to the excess of risk-taking by encouraging an increase in lending.
“In the 2000s in the US, regulators were hauling the banks in front of Congress to urge them to make more aggressive loans because they weren’t helping to stimulate property ownership in the US – and we know how that turned out,” says O’Keefe. “Of course, now regulators are doing the opposite.”
Good on balance sheets
The great advantage of doing the opposite is, of course, the effect on bank culture. Over the course of seven or eight years, problem assets have been purged from the balance sheets of major banks, and been replaced by low-risk assets. Cash, interbank deposits, liquid assets and triple-A-rated government bonds – all zero-risk-weighted assets – have tripled as a proportion of bank balance sheets, according to O’Keefe. Regulation has been fundamental to this shift; David Rule, an executive director at the Bank of England, recently claimed that capital requirements at UK banks are now seven times what they had been prior to the crisis.
For O’Keefe, therefore, financials now look exceptionally attractive, thanks to the combination of attractive stock valuations, positive capital dynamics and good asset quality. Citigroup, to give just one example, has seen deposits rise from around 35% of assets to around half.
“There has been a massive transformation of capital,” says O’Keefe. “From an investment point of view, banks are now way, way cheaper – even below liquidation value, in some cases. Liquidity is better, funding structures are better, and the assets are in better shape. These are the reasons we have gone from 0% in banks to 17% in banks.”
Yet if the fundamentals look increasingly sound, the problem of perception remains. The press continues to attack the culture of the big banks, while public distrust remains high. In this environment, banks will always be vulnerable to politics.
“If you watched the Democrat–Republican debates recently, you’d have heard candidates tripping over themselves to bash banks,” says O’Keefe. “Nevertheless, I believe that politicians and regulators are increasingly accepting that just penalising shareholders, eroding capital reserves and diminishing the lending potential of the economy is not the answer.”
Thus, although O’Keefe recognises the ongoing risks faced by the sector, he also believes we are closer to the end of the attack on the banking system than to its beginning.
“Banks have paid out regulatory fines and provisions and settlements with governments to the tune of $260bn,” says O’Keefe. “That’s equal to the market cap of Citigroup, Royal Bank of Scotland and Lloyds combined.”
“That value has been flushed out of the pockets of shareholders to society at large,” he says. “And so you have to think what happens over the next few years if that money-flushing stops. If the banks stop being used as piggy banks and the money starts coming back into the pockets of shareholders, well, that’s a huge, huge, huge sum.”
Dan O’Keefe is manager of the Global Managed fund. The opinions expressed are those of Dan O’Keefe and are subject to market or economic changes. This material is for information only and is not a recommendation or intended to be relied upon as a forecast, research or advice. The opinions expressed are those of Dan O’Keefe and are subject to market or economic changes. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.
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