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Financial textbooks laud companies that earn more from their equity than the equity theoretically costs. Otherwise, company value is eroded. Despite this dictum, top UK banks often promise shareholders returns on equity that fall short of cost. That might explain why bank valuations including price to earnings and price to book are at historic lows.
Those low multiples suggest investors want to see more ambition from banks. This puts bank executives in a difficult situation. Cutting costs only goes so far to improve profitability against capital. What is needed is a way to reduce the denominator — the capital employed both to run the bank and satisfy regulators.
Since early 2021, Barclays has promised that it will beat a 10 per cent return on tangible equity (ROTE). But as 2024 dawns, the cost of equity is much higher at about 20 per cent.
Even NatWest, which has the confidence to promise a 14-16 per cent ROTE, gets little respect. Its shares trade a fifth below its tangible net worth. UK banks need to get their ROTE into the mid-teens or higher to cover their cost of capital. While Barclays has some way to go, NatWest looks undervalued.
Chief executives are not sitting on their hands. They regularly cut costs and seek new sources of fee income that can raise profits. They can increase dividend payouts and share buybacks, given their relatively cheap shareholder equity. Both should help reduce the denominator in ROTE. This year the total distribution share yield for UK domestic banks should be over 13 per cent, according to UBS forecasts.
The amount of regulatory capital required by banks weighs down their ROTE. Some try to reduce their risk-weighted assets. Regulators allow banks to originate loans and then share the credit risk with specialist investors, both alternative asset managers and also insurers. More banks have turned to this method in recent years as higher capital Basel III rules come into force.
But European regulators review each one of these capital-relief structures. That bottleneck slows things down. One specialist in the area thinks that banks will do more of this capital-relief syndication, doubling to just 10 per cent of total loan books. But it will happen slowly.
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