The emergence of a new banking environment

The current operating environment is one of the most challenging ever for banks and although writedowns may be coming closer to an end, provisioning expenses are rising against a deteriorating economic backdrop.

In this crisis (compared to previous banking crises), capital injections from governments have occurred at an earlier stage in the economic downturn.

Arguably, the chief reason for the earlier action this time has been the mark-to-market writedowns that have undermined balance sheet stability and produced severe dislocations in credit markets globally. We have squarely moved from a phase of mark-to-market writedowns to a full-blown credit and impairment cycle.

In some countries and for some institutions, we are rapidly approaching the end game, finally having moved away from temporary piecemeal solutions toward comprehensive policy programs aimed at restoring financial market stability and improving confidence and sentiment.

As Ben Bernanke said recently, there will be ‘no more Lehmans’. What this implies is that in the US at least, large financial institutions are effectively going to be guaranteed by the government.

State capital injections, liquidity provisions and other government liability guarantees are important in restoring confidence in the global financial system.

These types of actions and more general regulatory forbearance thus far have served to reduce the solvency risk among a number of global banks.

The announcement in the US of the Private Public Investment Fund (PPIF) is another important step in restoring stability to the banking system.

The PPIF is essentially a two-pronged approach to purchase ‘legacy’ assets (in banking speak ‘toxic’ is now taboo), providing scale (purchasing up to US$1 trillion of assets) and, if implemented effectively, should serve to inject much needed liquidity into the banking system. It should also serve to set prices for these assets and provide some measure of asset price stability. Also, the PPIF is voluntary and, for it to work, requires participation from both private investors and banks.

Naturally, there are incentives for private investors (such as access to leverage) and banks (asset disposals). Yet there are also tough conditions where private investors would be subject to rigorous oversight by the Federal Deposit Insurance Corporation (FDIC), while banks would be forced to realise losses on assets that they have not already written down.

Assuming the PPIF is a success, this should be an important step toward cleaning up bank balance sheets, yet it still won’t resolve a widely held belief that the system still requires more capital. Expect therefore to see a number of stand-alone banks announce capital raising plans in this rally and leading up to first quarter results.

Historically, partial or full-scale government intervention that immediately reduced the solvency risk of the banking system has been a catalyst for a sustainable re-rating of the banking sector.

Previously, government intervention has served to stem sharp declines in asset prices, allowed banks to organically strengthen capital bases through retained earnings and reduced counter-party risks.

What remains to be seen (for those banks that now have government ownership in particular) is whether governments will use their increased ownership stakes in banks to force banks to lend more or to ease terms of credit.

The banks that will be strongly vindicated will be those that have stuck to a disciplined approach to banking and which did not compromise balance sheet quality for the sake of short-term growth.

For the banks that can maintain access to funding there will be some tremendous opportunities in banking.

Margins for banks are expanding, and banks that have money to lend can do so selectively based on stricter credit criteria. The risk to bank lending is much lower than it was on the average loan during the lending boom years and the future return on equity will be higher.

The banks that have adopted the following priorities will most likely emerge strongly from this current crisis:

• more balanced growth profile;

• solid retail banking model;

• focused on deposit growth (funding stability);

• well diversified commercial banking operations;

• margin management to reflect the scarcer liquidity and rising spreads; and

• conservative balance sheet and credit management.

Complex structural changes will continue to be mooted with regard to the entire global financial framework. However, the system will only be able to accommodate these changes over time.

We will continue to look closely at and monitor banks which have these sorts of priorities as well as those that look attractive on a capital-adjusted basis.

Matthew Hegarty is a senior equities analyst at Global Value Investors.