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PwC predicts a potential 20% bounce back in bank valuations over 1-2 years as investor confidence returns and the cost of equity subsides

Posted: 14th August 2012 08:53

Banking industry reforms and weak growth will keep bank equity returns at around 10%, but reduced equity costs and renewed investor confidence could allow a steady return to economic profitability and a strong recovery in share prices, according to a new PwC report, “Banking industry reform – A new equilibrium”, launched today.  While expectations that bank equity returns can return to the mid-teens are unrealistic, and efforts to meet those expectations are both futile and potentially destructive, the cloud could have a silver lining if banks can adapt themselves to a new world order and overcome the deep crisis in investor and stakeholder confidence.

The report envisages a post-crisis equilibrium in which bank equity costs fall to 8%-10% following reform-driven reductions in bank leverage and a gradual return to financial market normality. While capacity overhang, competitive pressures, subdued underlying economic growth and a substantial adjustment and compliance cost burden will continue to impact performance severely in the short term, and keep long run equity returns to no more than 1-2% over equity costs thereafter, even this expectation should support a substantial re-rating of bank stocks.

PwC analysis

Miles Kennedy, financial services partner and author of the report, PwC, said:

"While new capital ratios dilute returns to equity holders, they also dilute risks to equity holders and this has yet to be factored fully into equity cost calculations and forecasts. This has knock-on implications for investment criteria, product pricing, bank strategy and bank valuations.
“Historically, banks have resisted equity financing, preferring to boost equity returns through debt leverage. Investors have supported this and policy makers / regulators have consented. The world has now changed and banks and bank investors need to adapt, recapitalise and reposition for the future. The key obstacle is the continued undermining of investor confidence through a succession of banking scandals and wider economic and regulatory uncertainty. Banks, regulators and investors have an obvious part to play in turning this around and should make this a priority.

“Once confidence returns, we should see a new equilibrium emerging with a return to modest positive economic spreads. We should also see a re-rating of bank stocks from their current – in some cases heavily discounted – levels.

“Even as banks react to industry reforms in the short term, it is crucial that they adapt to the changing industry dynamics for the longer term. While some banks in less impacted regions and markets, or with stronger legacies, might feel less compulsion to adapt, there are ample opportunities for those with the foresight, leadership and resources to take advantage of them.”

Report key themes:

 - A permanent shift to a new banking equilibrium:  a new equilibrium will emerge in terms of performance benchmarks, industry structures, business models, financial structures, taxation, products, pricing, conduct and remuneration.
 - Bank responses could be counter-productive to themselves and to the economy. More intervention is likely.
 - Banks and bank investors need to re-set expectations: a return to return on equity in the mid-teens is unrealistic and unnecessary.  We estimate that the cost of equity will subside to 8-10% as bank balance sheets are strengthened and the systemic riskiness of bank assets returns towards historical norms.
 - Banks need to reinstate ‘economic’ decision tools, not get drawn further into regulatory models:  although regulation dictates aggregate capital requirements, they should not be a distraction from business decisions in areas such as business mix and deal pricing.
 - Fresh equity is sorely needed, but the confidence crisis needs to be overcome.
 
Miles Kennedy, financial services partner and author of the report, PwC, concluded:

"The financial crisis has changed everything.  Policy makers and regulators are leading the reform and forcing the pace, but they are only the catalysts.  The real drivers - the expectations of a wider set of stakeholders, and the realities of a new economic and commercial landscape - will fundamentally and permanently reshape the banking industry. In their responses to current industry reforms, banks need to have clear goals and contingencies for the future - dealing with the crisis in the short term while emerging from it in good shape for the longer term.”