Influx of Capital May Be Reason for Optimism

May 13, 2010 at 1:27 PM
It is easy to be discouraged about the prospects for the industry’s return to normal levels of profitability. Each day seems to bring a new brainstorm from elected representatives, industry pundits, or ex-regulators aimed at addressing a perceived problem with the industry that needs to be fixed. Invariably, the proposed solutions entail - implicitly or explicitly – imposition of higher capital requirements, higher compliance costs, or restrictions to operating powers.
The list of proposed fixes is long. To cite a few: creation of a Consumer Financial Protection Agency/Bureau, systemic risk oversight, expanded resolution authority, changes to FDIC assessments, increased capital and liquidity levels, restrictions on proprietary trading, restrictions on asset-backed securitizations, and derivatives reform. The thought of complying with these changes is simply dizzying, as is the associated degree of uncertainty they create about the future of the industry. The ongoing debate has many bankers wondering what else lurks around the corner.
Rarely are concerns voiced within public policy circles about the implications that these proposals might have on industry competitors to fulfill their primary purposes: to act as financial intermediaries to facilitate the efficient allocation of capital and credit.
Banks must have capital to fulfill this role. To attract this capital, banks must be able to earn an attractive return for investors. But the fixes proposed for the industry, together with previous fixes such as the Card Reform Act and the regulations on overdraft fees, raise well-founded concerns about industry profitability going forward.
Many banks have already cut costs, so there is limited ability to offset negative financial effects of proposed fixes through expense reductions. Our analysis shows that the fixes, absent an increase in revenue, will cause average ROEs to fall into the single digits.
Yet with all the uncertainty and mischief being caused by actions in Washington, banks and thrifts continue to succeed in attracting capital. According to SNL, banks and thrifts raised $11.4 billion in common equity from Jan. 1 through May 10 as more institutions seek to repay TARP, cover loan charge-offs, or to facilitate M&A activity. Unlike in 2009, the capital raises are not restricted to big banks. Community banks and regionals have participated as well.
Synovus Financial Group, plagued by problem residential development loans in the southeast, raised $1.1 billion in capital last week, so these capital raises cannot be attributed to investors seeking to benefit from a presumption of a Too Big to Fail policy. In additional to the public capital raises, there are recent instances of private equity funds making investments in community banks.
Why are investors placing capital into the banking system? Admittedly, investments to date have been made on terms attractive for investors. Also, some of the capital is likely being invested on expectations of quick paybacks through M&A activity. But our sense is that investors must also believe that the industry will be able to generate competitive returns in the not-too-distant future. The challenge will be for bank management to figure out how to make that happen.

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