US banks in activists’ sights as lenders struggle to hit targets
By Ben McLannahan
It was all very civilised.
When ValueAct, the activist investor, announced that it had taken a 2 per cent stake in Morgan Stanley earlier this month, it said it had every respect for the strategy set out by James Gorman, chairman and chief executive of the Wall Street bank.
The San Francisco-based fund manager said in a letter to its own investors that it looked forward to “developing [its] relationship with management to work towards a long, successful investment”. Morgan Stanley, for its part, said it welcomed ValueAct as a shareholder, like it would any investor.
But analysts say that relations could get a little more strained if Morgan Stanley continues to fall short of Mr Gorman’s key profit target: a return on common equity in the 9 to 11 per cent range. The bank is aiming to achieve this by the end of 2017. But in the first half of this year, its ROE came to an annualised 7.2 per cent, as it posted only a modest rebound in the second quarter from a very rough start to the year.
If a few more quarters go by without much progress, ValueAct — now a top 10 shareholder — could “take a more activist role, to hold management accountable”, says Brian Kleinhanzl, an analyst at Keefe, Bruyette & Woods in New York.
For any activist, the US banking sector is a target-rich environment. Almost eight years on from the depths of the financial crisis, many banks are still not making the double-digit return on equity which has long been seen as an acceptable threshold for profits. Only one of the big six — Wells Fargo — is expected to meet that basic benchmark this year, according to analysts’ forecasts.
However, shareholders are prepared to allow the banks some leeway. Many recognise that making money from the business of banking is harder than it used to be. If ROEs have shrunk, they say, it is not only because low interest rates make it harder to earn big profits from lending. It is also because the denominator — the E of equity — keeps rising.
Through the annual stress tests conducted by the Federal Reserve, for example, the biggest banks are made to operate with capital buffers big enough to withstand an Armageddon-like scenario.
“The guys managing banks are not asleep at the switch; they’re trying to compete in a ridiculously tough environment,” says Doug Burtnick, deputy head of North American equities at Aberdeen Asset Management in Philadelphia.
But those twin pressures — low rates and high capital — show few signs of easing. The best way for banks to respond, say analysts, is to keep hammering down on the things they can control, namely costs, while pouring more resources into activities which require less equity capital to grow.
If not, more activists could come knocking.
“Enough of a free ride for these management teams,” says Mike Mayo, an analyst at CLSA. “There’s only so long investors can sit around waiting for adequate returns.”
That activists have not bothered the banks much so far, is partly a function of size. These are very big bites. ValueAct’s $1.1bn investment in Morgan Stanley represents just 2 per cent of the shares outstanding.
Investors also recognise that banks have only limited room to manoeuvre to boost their ROEs. In this, the sixth year of annual stress tests, the Fed was willing to let only a couple of midsized banks hand back more than 100 per cent of their profits through dividends or buybacks. For the rest, equity bases keep rising. The 33 banks which took the full public test this year increased their combined equity capital by more than $700bn, to $1.2tn, over the seven years to the first quarter of 2016.
Roy Smith, a finance professor at NYU Stern, notes that this creates a tricky backdrop for Morgan Stanley to try to wring better returns from a business model in which the consistency of wealth and investment management revenues offsets the ups and downs of trading.
Even so, analysts expect the bank to produce an ROE of 6.7 per cent this year, and 7.5 per cent next year; short of the bank’s target, and well short of Mr Smith’s own estimate of a cost of equity of about 16 per cent. He uses a technique known as the capital asset pricing model to get there: combining the 10-year Treasury yield of about 1.5 per cent, with the equity risk premium (about 6.2 per cent) multiplied by Morgan Stanley’s “beta” — or its sensitivity to broader market movements — of 2.3 per cent.
If ValueAct gets traction, other management teams should stand ready to defend themselves, he says. He adds that for too long the entire US banking sector has been “adrift”, failing to address one fundamental question.
“If you’re in a business where your cost of capital is greater than your return, someone should ask you, ‘why is this a viable business?’”
Bank Leumi sees ROE expectations drop
The way Avner Mendelson sees it, eight is the new 10. Such are the burdens of ultra-low interest rates and ever-higher capital requirements, that the CEO of the US arm of Bank Leumi, Israel’s biggest bank by assets, feels that expectations for return on equity have come down too.
“In a zero-rate environment, as great as you are, much higher rates are not sustainable from a core banking business,” he says. “It means you’re taking significant risk, which just doesn’t add up.”
In the first half of this year Leumi’s US business had an ROE of about 6 per cent, after stripping out one-off factors. The former McKinsey consultant now wants to push higher by doubling down on the bank’s favoured niches in the US such as nursing-home finance and commercial real estate.
“To me that is the game,” he says. “You can talk about ROA — return on assets — all you want, but we are in the ROE business.”