What makes a bank a great investment for shareholders?
In January 2007, the management consultants Mercer Oliver Wyman named Anglo Irish Bank “the best bank in the world”. By April 2011, to bail out Anglo had cost the Irish taxpayer around €30bn. To be fair to MOW, in January 2007 the share price had risen 2,000% in just seven years, as the market cap of the bank went from €600m to over €12bn. €1,000 invested in Anglo in 2000, would have been worth €20,000 seven years later.
But if not phenomenal historic growth, what makes a bank a great investment for shareholders? Simply asking investors is not straight forward. For instance, when Sir Tom McKillop took over as Chairman of Royal Bank of Scotland he was concerned about Fred Goodwin’s management style. He commissioned a confidential report, to canvass opinion among the bank’s top twenty shareholders and received favourable feedback on Fred. Following this, McKillop decided that the owner’s of the bank were happy, and he should not persuade Fred, who had been Chief Executive since 2000, that he was in danger of outstaying his welcome.
It might not be a good idea to ask customers what makes a good bank either. Although customer service and relationship banking are viewed positively, sometimes they can be taken too far. Sean FitzPatrick created a model at Anglo Irish Bank where his lenders formed strong bonds with their customers. Years later, in 2011 when the Finnish banking expert Peter Nyberg published the findings of his investigation into the systemic failings in Irish banking, he concluded that “Anglo found it quite difficult to decline a loan to any of its traditional top customers.” That is, the the wealthy property developers who were Anglo’s most profitable customers, were effectively running the bank. Indeed, Sean Quinn one of Anglo’s largest customers believed that Anglo was such a great bank, that he bought around a quarter of its outstanding shares, using a Contract For Difference. Effectively, Quinn borrowed billions of Euros, to invest in a bank, that was lending him billions of Euros. When things began to unwind, this caused no end of problems and Quinn eventually went bankrupt, followed by a term in prison as the Irish authorities showed that he had not co-operated with the Irish Bank Resolution Corporation (IRBC) and instead he was hiding assets offshore.
Although both Anglo Irish and Royal Bank had fantastic track records and were widely praised, both banks’ share price were trading at p/e ratio discount to the likes of Standard Chartered and HSBC, suggesting that some investors had concerns. So perhaps, when RBS Chairman Sir Tom McKillop was looking for honest feedback on Fred’s management style, he should have sought the opinions of a wider section of the investment community, not just the top 20 shareholders. For instance, one analyst, James Eden, even suggested at the analyst meeting, that Fred was perceived as a “megalomaniac” and that the shares were discounting empire building at the expense of shareholder value. Ironically Eden thought the discount was unwarranted, and had a buy rating on the stock.
Another explanation is that in 2006 Royal Bank operated with an equity tier 1 ratio of just 4%, net equity (less goodwill) of £18bn and total assets of £871bn. Net equity was almost 50x leveraged. In 2006, Sir Tom McKillop asked Fred about the low tier 1 ratio, and Fred replied that investors feedback was positive: institutional investors in RBS liked the “efficient” capital ratios.. By December 2007, with the acquisition of ABN, total assets had doubled to £1.9 trillion, with no increase in equity funding. As the share price headed lower, institutional funds were signalling they preferred other, more conservatively financed banks, such as HSBC and Standard Chartered.
A related explanation for the discount comes from Patrick Barton. The fund manager looked at the five year trend in Returns on Invested Capital (ROIC defined as equity, plus subordinated debt). As competition increased in UK banking, net interest margins declined, yet Returns on Equity remained apparently attractive at 20%. To square the circle of pricing pressure, but high reported returns on equity, the bank had, without telling one explicitly, reduced equity funding, effectively gearing up the returns and increasing risk. Barton published his findings in a research report in 2004, also prophetically warning that
“In theory, once an acquisition is completed, group ROIC should gradually improve as economics of the underlying business begin to show through (goodwill reduces as a proportion of invested capital); in practice, where one acquisition leads to another, this doesn’t happen. In our experience (both inside and outside the sector), the process generally only concludes with a bad deal.”
So perhaps Sir Tom, when he became Chairman, should not have asked the owners of Royal Bank what they thought. Instead to understand what makes a good bank, it is worth canvassing opinion from investors who do not own, or are underweight. What might their concerns be?
The answer seems to be the sustainability of past performance into the future. When Fred’s predecessor, Sir George Mathewson became Chief Executive in 1992, profit was just £21m. By the time he left the bank in 2006, profit had risen to £8.3bn. Market cap had increased from £1.6bn to £60bn over the same time. There was no way that any new Chief Executive could hope to deliver that kind of growth over the next 15 years.
That is, both RBS and Anglo Irish, suffered the same fate. As they became bigger, they also became riskier. Because by dint of size alone, the track record became ever harder to sustain. With that in mind, it is worth pondering why Chief Executives were attempting to grow so quickly, and outpace the market. In banking size is often perceived as an advantage, “economies of scale”, yet for investors what makes a good bank is sustainability of returns, and scale is the very enemy of that goal.
Asset managers too, who charge a percentage of assets under management, also enjoy incentives to grow large rather than concentrate on achieving high returns. When I introduced Bank of Georgia to investors in London the investment case met with a lukewarm response.
This, for a bank with 30% market share, a 20% return on equity, and 20% tier 1 ratio lending to a population with a low level of indebtedness (mortgages were 4% of GDP at the time). Most of the feedback from large funds, was that the bank was too small and illiquid to invest in. Management did not have much of a track record. At the time the market cap of Bank of Georgia was £230m, below that of Anglo Irish or Royal Bank before their phenomenal shareholder returns. Not many of the members of the large fund managers, the so called “smart money” invested. Had they done so, they would have trebled their investment in the following 2 years. In time investors will recognise that large size and sustainably high returns, are two different goals.
Source: Anglo Republic: Inside the Bank that Broke Ireland, Simon Carswell
Making it Happen: Fred Goodwin, RBS and the Men who Blew up the British Economy Iain Martin
Now you listen here..WdB RBS 16Jun04
Looking forward to reading more. Great blog post. Much obliged.