Frontpage News 2016 Column in Finanswa...

Ulrik Nødgaard’s column in Finanswatch on required rate of return

15 August 2016

​In a new column published in Finanswatch, Ulrik Nødgaard writes that living up to the required rate of return set by investors does not necessarily lead to excessive risk taking. Uncertainty drives required rates of return up. An-other important point seen with the sector’s eyes is that the uncertainty about the new impending regulation from Basel contributes to increasing investors’ required rate of return. This is a point of view that the Bank of England shares with the Danish Bankers Association.

Uncertainty on regulation keeps required rate of return for banks high
By Ulrik Nødgaard, CEO of the Danish Bankers Association

What is a reasonable required rate of return for bank shares? This is the question that the financial sector repeatedly faces. And in a world where risk-free interest rates are very low and where banks are considerably better capitalized than previously, attention and perhaps puzzlement has been brought to the fact that the required rate of return on bank shares is still very high.
Analysts still use typical required rates of return in the region of 10 pct., when they need to discount expected future revenue in order to value shares. The Central Bank of Denmark recently published a study based on a range of premises indicating that the de facto required rate of return may have declined to 8 pct. Based on the latest consensus estimates for the up-coming years’ revenue, the share price at the beginning of August for Dan-ish banks currently corresponds to a required rate of return of between 7 and 12 pct. But whichever way we look at it, required rates of return of this size are significant in a world, where risk-free interest rates in reality are zero.
This spring, the Central Bank of Denmark and the Danish FSA both ex-pressed concern that banks have a target rate of return on equity that is higher than the required rates of return. If we look at revenue and business in the eyes of investors – a natural starting point – we should perhaps also remember that a company first creates added value when return on equity is delivered that surpasses the requirements that investors had. And it is, of course, natural that bank management, for example, has a clear ambition to create this value and “deliver the goods”.
The authorities’ concern is based on the fact that a high target rate of return on equity would pressure bank management to “move out of the risk curve” in order to deliver a high return on equity. We should remember that return on investment can be increased by many other channels than by increasing risk appetite. Firstly, we can try to grow in areas that are not perceptibly risky. Optimal examples of this are private banking and investment management, which many banks have also increased focus on in recent years. Secondly, expenses can be cut. This can already be seen in all Danish banks – streamlining and consolidating at fewer addresses with fewer branches and even banks’ main offices are increasingly coming into play in the efforts to lower costs. Finally, credit management is also a way to higher revenue, as banks get the right customers at the right price. So, higher revenue does not necessarily mean increased risk taking.
The Central Bank of Denmark and the Danish FSA must, without doubt, be aware and call out, if they see signs of excessive risk appetite. But as long as there is no sign of it, robust revenue is a premise for robust banks. The Deputy Chief Executive at the Danish FSA, Flemming Nytoft, wrote (togeth-er with his co-authors) in the published work Dansk Bankvæsen: “… it is crucial that financial institutions reach a reasonable return on invested capi-tal. It is a prerequisite for ensuring capital base and thereby for being able to accommodate credit intermediation in line with increased economic ac-tivity.” The ability to generate revenue also plays a central role, when rating bureaus evaluate banks. As Standard & Poors writes, the ability to generate revenue is “the first line of defence against losses.”
A key part of the picture is that Danish banks’ return on investment cannot be seen in isolation from the rest of the world. We need to remember that we are part of, not only a European, but also a global financial market. A (hypothetical) scenario, where Danish banks continuously delivered consid-erably lower return on investment than banks in surrounding countries, would hardly be conducive for the banks’ rating or financial stability.

It is wishful thinking that other countries’ banks would have lower revenue requirements than Danish banks. The EBA’s latest questionnaire on risk as-sessments was published on 30 June having asked 39 of the largest banks in Europe about the requirements they face for return on equity in order to ensure that business models are durable. More than four out of five an-swered that return on equity is over 10 pct. However, if authorities wish to sink expectations of banks’ return on investment, then there are several ways where they themselves could lend a helping hand.
As Sir John Cunliffe from the Bank of England recently pointed out, high expectations about bank revenue should be seen in the context of investors needing to be compensated for the continued uncertainty and future regulatory requirements. For example, how should we value trading activities in a bank with a view of the “fundamental review of the trading book”, where through keeping bonds, capital requirements on the book can potentially more than double. Valuation of a mortgage portfolio depends, of course, on whether the risk adjustment on such a loan is 15 pct. (a typical level for institutes today, who use IRB models) or 28 pct. (which can potentially be a reality with floor of 80 pct.). In the so-called Basel IV package, there is a view of considerably larger capital requirements on lending to big “blue-chip” companies such as Danfoss or Lego.
As stated in a recent analysis from one of the leading investment banks, “Uncertainty related to these requirements has justified part of the premium in the cost of equity for the sector relative to the market.” So, authorities actually have the option of contributing to reducing required rates of return for banks, if they think they are too high, by removing the cloud of regula-tory uncertainty hanging over European banks. It is partially about tying a bow on regulatory initiatives, which have been launched in the wake of the crisis such as, Leverage Ratio, Net Stable Funding Ratio, requirements on liabilities suitable for write-downs and new accounting rules. However, just as importantly, it is also about ensuring that the Basel IV package does not lead to significantly higher capital requirements.
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