It is not the done thing for management teams to talk back to investors at meeting, which is a pity. When someone has reached the top of their profession and inspired the loyalty of thousands of employees, it is never especially edifying to see them cringing and taking notes while a junior hedge fund analyst tells them where they are going wrong.
This, though, is the start of the results season so it is time for fund managers to walk into corner offices and reiterate to the titans of the banking industry: “A single-digit return on equity just isn’t good enough.”
This makes less sense than one might think. If social mores were different, an obvious response for most bank chief executives, especially investment bankers, would be: “You loved this business when it had equity-to-asset ratios of 2 per cent and a 16 per cent RoE. Why do you hate it now that it has 5 per cent equity to assets and a 9 per cent RoE?”
Take Barclays, criticised since the crash for lacklustre returns. In 2006, at the peak of Bob Diamond’s fame and pre-crisis fortunes as head of Barclays Capital, the UK-based bank made £4.6bn profit on average assets of £950bn — a return on assets of 0.5 per cent. In the first half of last year, Barclays made £2.2bn profit; and the business had average assets of £872bn. The annualised return on assets was almost the same. If Barclays in 2015 had operated with the same gearing, or debt-to-equity ratio, as in 2006, it could have declared a 20 per cent RoE for its core operations, rather than the 11.1 per cent it announced.
The market is not giving Barclays credit for this unchanged underlying profitability. It currently trades at a substantial discount to the rest of the European banking sector, as do many other banks that have increased equity levels, lowered RoE and suffered the consequences. Financial theory suggests cutting the debt-to-equity ratio makes the equity safer and should therefore reduce the returns investors demand.
It also suggests that, logically, the RoE ought to be influenced by the return on other assets — when government bonds yield 1.5 per cent, it is hard to argue that the expected return on anything else should be more than 10 per cent. But surveys still suggest that people expect a bank stock to earn at least 10 per cent and often closer to 12 per cent. Investors, it seems, do not understand that lower risk should mean lower return.
They did not understand it during the good times, either. Andy Haldane, chief economist at the Bank of England, noted in his 2011 Wincott lecture that the growing fixation on RoE as the measure of performance from the 1990s onwards was associated with more leverage, more risk-taking and more short-termism. The indexing of management compensation plans to this flawed measure created a “myopia loop”, as chief executives were given incentives to add volatility to their assets and reduce the capital that supported them.
Subsequent experience has reinforced Mr Haldane’s point, albeit not in the way one might have foreseen. The regulatory pendulum turned, requiring the banks to finance themselves with much more equity on their balance sheets. Since nothing much happened to change the profitability of the actual business, a doubling in the amount of equity was bound to halve the RoE.
Other changes to the capital regulations made it harder to bring returns back up by loading up on risk. But since the bankers were still required by their investors to earn a double-digit return, they continued to act myopically.
The decimation of Barclays Capital illustrates perfectly the problem of short-termism in modern capitalism. It was an excellent business with strong franchises before the crash. It could have returned, like the US banks, to profitability — but it needed capital investment. Instead it lost staff, capital and goodwill purely in response to pressure from shareholders to make the short-term return on equity look better.
The fixation on earning a double-digit return has probably had consequences for the long-term profitability of Barclays and many other European banks, which tended to have higher gearing before the crisis.
“Market discipline” is one of the three pillars of global bank regulation. The post-crisis increase in capital requirements was premised on the assumption that the market would be rational, and would be prepared to provide capital on a basis that recognised that lower gearing meant lower risks. This does not appear to have happened.
The writer is a former investment banker and a senior research adviser at Frontline Analysts, a provider of equity research