Is now the time to invest in banks?

9th September 2013

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UK and other developed world banks are now “largely fit for purpose” according to Guy de Blonay, manager of the Jupiter Financial Opportunities fund.

In note marking the five year anniversary of the collapse of Lehman Brothers, de Blonay says regulators still have to deal with the tricky issue of banks that are “too big to fail” while global imbalances fuelled by years of low interest rates remain a concern.

He adds: “The collapse of Lehman Brothers on 15 September 2008 has proved a defining moment for many working in the global financial industry. Brought down by its exposure to the sub-prime mortgage market, the demise of the 158-year old investment bank has come to embody an era where light-touch regulation and weak regulatory supervision fuelled a culture of excessive risk taking.”

“Five years on, better policing by politicians, regulators and the banks themselves have, in our view, transformed the way financial institutions go about their business. Yet challenges remain. Even if the nascent economic recovery bodes well for the sector, the global imbalances sparked by years of ultra-low interest rates could prove tricky to negotiate while the issue of banks that are “too big to fail” has yet to be fully addressed.”

De Blonay suggests that the regulatory and legal framework put in place since 2008 has managed to restore investor confidence in financial stocks.

He points out that the MSCI AC World Financials Index up 149.9% from its post-Lehman low point in March 2009.

He says the key regulatory milestones include –

In the US – the passing of the Dodd Frank Act in 2010 that gave to the Federal Reserve tough new powers over US banks.

In Europe – A political will to implement cross-border oversight of the sector with the creation of the European Banking Authority in 2011.

In the UK – Sweeping changes to the way banks are supervised and new legislation that will see retail banking ring-fenced from investment banking activities, have placed a tighter regulatory leash on the sector.

Globally – Basel III rules in the same year that forced global banks to adopt stricter capital and liquidity requirements.

The note continues: “We believe the major reforms required to make banks “fit-for-purpose” have largely been implemented. Any further measures are likely to be no more than tinkering at the edges, although reform is always likely to be an ongoing process given the complexity of the sector.

“It is telling that the Glass Steagall Act that so famously brought in the separation of retail and investment banking operations in the US after the financial crash of 1929 ran to just 37 pages and lasted 66 years. By comparison, the rules and regulations set out in Basel II took up 347 pages and lasted just four years.”

In a view that is sure to interest many investors, De Blonay believes that banks will start to increase their dividend policy.

“The Federal Reserve signalled its renewed confidence in the sector as early as March 2011 when it allowed leading US banks to start paying dividends again and buying back stock. With most banks now well capitalised, we can expect a growing number of them to boost the amount of cash they return to shareholders, and for some of them to resume paying dividends.

“It is those banks with growing pay-out ratios that we favour today in our portfolio as long as they are attractively priced. Other banks are in the process of undergoing extensive restructuring in the wake of the financial crisis and these appeal to us for their recovery potential. The fund is very different in look and feel from five years ago when cash was king and owning defensive stocks was vital to resist the downturn in the global economy.”

He says that reforming the banks has been helped by the ultra-low interest rate environment brought about by quantitative easing QE but there is an obvious downside and banks will have to tread carefully.

“With central banks offering to provide cheap credit through billion-dollar bond buying programmes, banks were given the opportunity to recapitalise cheaply as they restructured. The unfortunate side effect of this flood of cash is that it has also enabled asset bubbles and imbalances to form in different parts of the global economy as investors have moved this cheap money into asset classes and regions, notably emerging markets, where they have been able to maximise their returns.

“Now that the Fed has signalled its plan to pare its bond buying programme, markets are likely to remain volatile as investors adjust their portfolios for the end of QE and a time, in the not too distant future, when rates will rise again. Against this backdrop, banks will have to tread carefully.”

The note concludes by considering the fact that investors will eventually have to be weaned off the idea that there are some financial institutions that are just “too big to fail.”

It adds: “It has been a key principle underpinning the stability of the global capital markets although we would argue a flawed one. With the right procedures in place, there should be no reason a poorly-performing bank cannot be allowed to fail. If it is done in an orderly fashion, it should pose no threat to the stability of the broader financial markets.

However a big failure would still have big consequences.

The note adds: “Regulators have been looking at practical ways to wind down a bank including living wills, ring-fencing and bail-inable debt but the feeling remains that the failure of a large global bank would still have the power, five years on from the collapse of Lehman Brothers, to send markets in a tailspin.”

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