Thinking aloud about Australian bank ROE

I have been wanting to put something down on the question of Australian major bank ROE for a while. The issue generates a lot of heat but the public discussion I have observed has been truncated, in my opinion, by misconceptions.

I think we can agree that banks need to be profitable to be healthy and a healthy banking system underpins the health of the economy as a whole. Excessive profitability however is clearly bad for consumers, business and for the economy as a whole. The problem is determining what level of profitability is excessive. This post is unlikely to be the final word on this topic but hopefully it introduces a couple of considerations that seem to me to be largely missing from the public debate.

Most of what I read on this topic seems to treat the ROE of the Australian majors as self evidently excessive and focuses on what to do about it. Exhibit A is the reported ROE which in the 2019 half year updates varied from 10.05% to 14.10%. This is much less than it was but still substantially better than what is being achieved by most banks outside Australia and by the smaller local banks. Exhibit B is the fact that the Australian banking system is an oligopoly which almost by definition earn excess profits.

Reported ROE exceeds COE – case closed

Any discussion of ROE must be anchored by the estimated Cost of Equity (COE), the minimum return that investors require to hold equity risk. There are a variety of ways of calculating this but all of them generate a number that is much less than the ROE the majors currently earn. So case closed.

There is no question that the Australian majors cover their cost of equity, but it is less clear to me that the margin of excess profitability is as excessive as claimed.

Corporate finance 101 teaches us that we can derive a company’s cost of equity using the Capital Asset Pricing Model (CAPM) which holds that the required return is equal to the Risk Free Return plus the Equity Risk Premium (ERP) multiplied by the extent to which the return the individual stock is correlated with the market as a whole. The general idea of being paid a premium for taking on equity risk makes sense but there are a bunch of issues with the CAPM once you get into the detail. One of the more topical being what do you do when the risk free rate approaches zero.

I don’t want to get into the detail of those issues here but will assume for the purposes of this post that a rate of return in the order of 8-10% can be defended as a minimum acceptable return. I recognise that some of the more mechanical applications of the CAPM might generate a figure lower than this if they simply apply a fixed ERP to the current risk free rate.

Two reasons why a simple comparison of ROE and COE may be misleading

  1. Banking is an inherently cyclical business and long term investors require a return that compensates them for accepting this volatility in returns.
  2. Book value does not define market value

Banking is a highly cyclical business – who knew?

It is often asserted that banking is a low risk, “utility” style business and hence that shareholders should expect commensurately low returns. The commentators making these assertions tend to focus on the fact that the GFC demonstrated that it is difficult (arguably impossible) to allow large banks to fail without imposing significant collateral damage on the rest of the economy. Banks receive public sector support to varying degrees that reduces their risk of failure and hence the risk to shareholders. A variation of this argument is that higher bank capital requirements post the GFC have reduced the risk of investing in a bank by reducing the risk of insolvency.

There is no question that banks do occupy a privileged space in the economy due to the central bank liquidity support that is not available to other companies. This privilege (sometimes referred to as a “social licence”) is I think an argument for tempering the kinds of ROE targeted by the banks but it does not necessarily make them a true utility style investment whose earnings are largely unaffected by cyclical downturns.

The reality is that bank ROE will vary materially depending on the state of the credit cycle and this inherent cyclicality is probably accentuated by accounting for loan losses and prudential capital requirements. Loan losses for Australian banks are currently (October 2019) close to their cyclical low points and can be expected to increase markedly when the economy eventually moves into a downturn or outright recession. Exactly how much downside in ROE we can expect is open to debate but history suggests that loan losses could easily be 5 times higher than what we observe under normal economic conditions.

There is also the issue of how often this can be expected to happen. Again using history as a guide for the base rate, it seems that downturns might be expected every 7-10 years on average and long periods without a downturn seem to be associated with increased risk of more severe and prolonged periods of reduced economic activity.

What kind of risk premium does an investor require for this cyclicality? The question may be academic for shareholders who seek to trade in and out of bank stocks based on their view of the state of the cycle but I will assume that banks seek to cater to the concerns and interests of long term shareholders. The answer for these shareholders obviously depends on how frequent and how severe you expect the downturns to be, but back of the envelope calculations suggest to me that you would want ROE during the benign part of the credit cycle to be at least 200bp over the COE and maybe 300bp to compensate for the cyclical risk.

Good risk management capabilities can mitigate this inherent volatility but not eliminate it; banks are inherently cyclical investments on the front line of the business cycle. Conversely, poor risk management or an aggressive growth strategy can have a disproportionately negative impact. It follows that investors will be inclined to pay a premium to book value for banks they believe have good risk management credentials. I will explore this point further in the discussion of book value versus market value.

Book Value versus Market Value

Apart from the cyclical factors discussed above, the simple fact that ROE is higher than COE is frequently cited as “proof” that ROE is excessive. It is important however to examine the unstated assumption that the market value of a bank should be determined by the book value of its equity. To the best of my knowledge, there is no empirical or conceptual basis for this assumption. There are a number of reasons why a company’s share price might trade at a premium or a discount to its book value as prescribed by the relevant accounting standards.

The market may be ascribing value to assets that are not recognised by the accounting standards.The money spent on financial control and risk management, for example, is largely expensed and hence not reflected in the book value of equity. That value however becomes apparent when the bank is under stress. These “investments” cannot eliminate the inherent cyclicality discussed above but they do mitigate those risk.

A culture built on sound risk management and financial control capabilities is difficult to value and won’t be reflected in book value except to the extent it results in conservative valuation and provisioning outcomes. It is however worth something. Investors will pay a premium for the banks they believe have these intangible strengths while discounting or avoiding altogether the shares of banks they believe do not.

Summing up …

This post is in no way an exhaustive treatment of the topic. Its more modest objective was simply to offer a couple of issues to consider before jumping to the conclusion that the ROE earned by the large Australian banks is excessive based on simplistic comparisons of point in time ROE versus mechanical derivations of the theoretical COE.

As always, it is entirely possible that I am missing something – if so let me know what it is ….

Tony

“The rate of return on everything”

This is the focus of a paper titled “The Rate of Return on Everything, 1870-2015 that seeks to address some fundamental questions that underpin, not only economic theory, but also investment strategy.

To quote the abstract:

This paper answers fundamental questions that have preoccupied modern economic thought since the 18th century. What is the aggregate real rate of return in the economy? Is it higher than the growth rate of the economy and, if so, by how much? Is there a tendency for returns to fall in the long-run? Which particular assets have the highest long-run returns? We answer these questions on the basis of a new and comprehensive dataset for all major asset classes, including—for the first time—total returns to the largest, but oft ignored, component of household wealth, housing. The annual data on total returns for equity, housing, bonds, and bills cover 16 advanced economies from1870 to 2015, and our new evidence reveals many new insights and puzzles.ets.

“The Rate of Return on Everything” Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, Alan M. Taylor – December 2017

The paper is roughly 50 pages long (excluding appendices) but the 5 page introduction summarises the four main findings which I have further summarised below:

  1. Risky Returns: The study finds that “… residential real estate and equities have shown very similar and high real total gains, on average about 7% per year. Housing outperformed equity before WW2. Since WW2, equities have outperformed housing on average, but only at the cost of much higher volatility and higher synchronicity with the business cycle”.
  2. Safe Returns: The study finds that “Safe returns have been low on average, falling in the 1%–3% range for most countries and peacetime periods“. However, “the real safe asset return has been very volatile over the long-run, more so than one might expect, and oftentimes even more volatile than real risky returns.” This offers a long-run perspective on the current low level of the safe returns with the authors observing that “… it may be fair to characterize the real safe rate as normally fluctuating around the levels that we see today, so that today’s level is not so unusual. Which begs the question “… why was the safe rate so high in the mid-1980s rather than why has it declined ever since.”
  3. The Risk Premium: The study finds that the risk premium has been very volatile over the long run. The risk premium has tended to revert to about 4%-5% but there have been periods in which it has been higher. The study finds that the increases in the risk premium “… were mostly a phenomenon of collapsing safe rates rather than dramatic spikes in risky rates. In fact, the risky rate has often been smoother and more stable than safe rates, averaging about 6%–8% across all eras” . This for me was one of the more interesting pieces of data to emerge from the study and has implications for the question of what should be happening to target return on equity in a low interest rate environment such as we are currently experiencing. In the Authors’ words “Whether due to shifts in risk aversion or other phenomena, the fact that safe rates seem to absorb almost all of these adjustments seems like a puzzle in need of further exploration and explanation
  4. On Returns Minus Growth: This is the question that Thomas Piketty explored in his book “Capital in the Twenty-First Century”. Piketty argued that, if the return to capital exceeded the rate of economic growth, rentiers would accumulate wealth at a faster rate and thus worsen wealth inequality. The study finds that, “for more countries and more years, the rate of return on risk assets does in fact materially exceed the rate of growth in GDP… In fact, the only exceptions to that rule happen in very special periods: the years in or right around wartime. In peacetime, r has always been much greater than g. In the pre-WW2 period, this gap was on average 5% per annum (excluding WW1). As of today, this gap is still quite large, in the range of 3%–4%, and it narrowed to 2% during the 1970s oil crises before widening in the years leading up to the Global Financial Crisis.

So why does this matter?

There is a lot to think about in this paper depending on your particular areas of interest.

The finding that the long run return on residential housing is on par with equity but lower volatility is intriguing though I must confess that I want to have a closer look at the data and methodology before I take the conclusion as a fact. In particular, I think it is worth paying close attention to the way that the study deals with taxation. Fortunately, the paper offers a great deal of detail on the way that residential property is taxed (Appendix M in the December 2017 version of the paper) in different countries which is useful in its own right. I have been looking for a source that collates this information for some time and this is the best I have seen so far.

For me at least, the data on how the Equity Risk Premium (ERP) expands and contracts to offset changes in the return unsafe assets was especially interesting. This observation about the relationship is not new of itself but it was useful to find more data in support of it. I have been thinking a lot about Cost of Equity in a low interest rate environment and this seems to support the thesis that the target Return on Equity (ROE) should not necessarily be based on simply adding a fixed measure of the ERP (say 4%-5%) to whatever the current long run risk free rate is. It is at least worth having the question in mind when considering the question of whether Australian bank ROE is excessive at this point of the cycle.

If you are interested in the issues covered above then it is also worth having a look at an RBA Research Discussion Paper titled “A History of Australian Equities” by Thomas Matthews that was published this month.

From The Outside