When is enough enough?

According to media, there were hard feelings at Nordea last week when Christian Clausen, Group CEO at Nordea, announced additional cost cutting measures on top of the 900 mEUR cost reduction target that was presented in January. This was the third time that management hiked the target for the cost reduction program. The cost reduction frenzy is not isolated to Nordea. I hear the same mantra from the other banks, often disguised with the catchphrase “Capital Efficiency”. Many, both customers to the banks and the banking employees, look at the profits reported by the banks and ask themselves when is enough enough. In this blog post, I will try to explain why the banking executives are not content even if they post profits that are almost on par with their results prior to the financial crisis that erupted when Lehman Brothers filed for bankruptcy in September 2008.

The chart below illustrates what happened. The blue bars represent the total net profit of the big four banks in Sweden. The pre-crisis year 2007 is used as baseline with the index 100. As you can see, the profits dropped to a third of the pre-crisis year in just two years. The profits have grown steadily ever since and are now a mere 3% from getting back to the same level as in 2007. But I am certain that restoring the profit levels will not be enough and you can see why in the orange bars. The shareholder equity has outperformed the growth of the bottom-line by far. It is the inflated equity that is the root cause to the top executive’s problem. They have to comply with the revised Basel directive that regulators imposed to ensure that banks resist the temptation to increase their financial leverage to improve the return to their shareholders. The effect on the Return on Equity (RoE) is illustrated with the dashed line. Though back on the same profit levels, the banks are currently only delivering 60% of the profitability that they delivered prior to the crisis.

Cynics may argue that the shareholders should accept lower Return on Equity for banks now when it is evident that the default risk is lower for banks than other industries. The reasoning may be applicable when pricing bonds issued by banks but I doubt that any investor consider the default risk when considering buying stocks in a company with an AAA or AA rating, regardless of industry. No, I think that the banking executives are stressed out by the fact that the Basel regulations limit them when trying to optimize shareholder value. They cannot increase their financial leverage and use any of the strategies for improved shareholder value that their counterparts in other industries devise. Nevertheless, they know that investors expect them to restore RoE to at least the same level as prior to the crisis. Christer Gardell and Björn Wahlroos are two tycoons that have made substantial investments in the banking industry and expect the executives to deliver, or find a new job in another industry. Christer Gardell and his company Cevian invested in Swedbank and were rumored to push for renewed discussions with SEB on a merger. They have sold their holdings in Swedbank but the top executives at Danske Bank are on their toes to deliver now when Cevian has emerged as one of their largest shareholders.

I think that is fair to assume that banking executives will try to optimize the shareholder value by optimizing the capital efficiency. They will a) try to minimize their shareholder equity within the boundaries of Basel III by divesting risky assets and adopting the advanced methods to calculate the capital requirements and b) minimize costs so that RoE is restored to the pre-crisis level. Please do not take me the wrong this way. I am not defending the increased cost focus among the banks. On the contrary, I think it is extremely unfortunate that the banks focus on the costs at the same time as the customer satisfaction levels are at an all-time-low. But I sympathize with the banking executives that are expected to do magic in the cross-fire of regulators, shareholders and customers that all are dissatisfied. Any missteps can quickly change the public mindset on banks from “too big to fail” to “doomed to fail”.

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