The Trump administration's vision of a rollback in banking regulation isn't just dubious medicine for the economy, it will do shareholders no favours.
That's because unleashing banks will likely bring on future rounds of boom and bust on Wall Street, creating the kind of volatile, low-quality earnings shareholders dislike and punish with lower valuations.
Treasury Secretary Steven Mnuchin in June released a regulatory reform blueprint which would exempt many U.S. banks from some stress tests of their ability to withstand economic and market foul weather. He also called for further exemptions giving most banks a free pass on the "Volcker Rule" prohibiting some kinds of speculative trades and holdings, as well as steps toward "transparency" which would likely make Federal Reserve stress tests less rigorous.
Randal Quarles, U.S. President Donald Trump's nominee for Federal Reserve vice-chair of regulation, is thought to be sympathetic to the view that regulation is holding back economic growth. Mr. Quarles, echoing Mr. Mnuchin, told his Senate confirmation hearing transparency should be a "theme of the Federal Reserve's regulatory activities."
What the administration can accomplish is unclear, but history shows investors neither like nor highly value free-wheeling big banks. The largest U.S. banks and investments banks have generally traded at multiples of earnings far below that of the stock market, and hugely below more highly regulated sectors such as utilities. The root issue here is the preference of investors for a stable stream of earnings from a growing company, as opposed to the preference of bank insiders for speculation and volatility. Insiders do well when banks are unleashed. Risk-taking drives up revenues, boosts annual bonus payments, and also creates the earnings and stock market volatility which makes the share options many traders and executives are paid in more valuable.
Investors, in stark contrast, want a quiet life and a steady return. Not generally fools, investors have noticed that the largest U.S. banks and investment banks have a long-standing habit, most vividly illustrated by Citigroup's performance in recent decades, of almost blowing themselves up every few years by taking on too much risk. In consequence, with the S&P 500 trading at a trailing price-to-equity ratio of just under 25, Goldman Sachs is at 12 while JPMorgan Chase, Citigroup and Morgan Stanley are all around 14. And those are multiples which have expanded more quickly than the broad market in the past year.
More earnings but worse quality
To be sure, the general expectation is that U.S. banks, unchained from burdensome regulation, will, as they do, earn more revenues. Analysts at KBW earlier this year estimated that the largest banks could get a cumulative earnings uplift of an average of 30 per cent from what it termed "regulatory relief." such as a dulling of the Volcker Rule and a fall in the extra capital U.S. banks must hold compared to global rivals.
Yet, a return to precrisis risk-taking would bring with it two things in addition to higher revenues. More of banks' earnings would walk out the door, as a bidding war for talent ensued, taking the share that banks pay of revenues in compensation back toward precrisis levels.
Roll back regulation and you might get a short boom in bank shares, if investors are willing to take those higher revenues at face value. But then again, they might not. Certainly if banks had another volatile cycle, long-term returns to the sector would be poor, and multiples of bank earnings the stock market will pay would shrink. And don't believe that the whole economic pie will grow if U.S. banks are freed up to make more loans. There is little evidence for that, as economists Stephen Cechetti and Kim Schoenholtz argue. They also say Mr. Mnuchin's plan would make the financial system less safe. Investors hoping the whole stock market will make them rich if banks lend more should look at how that worked out in 2005-07.If you really want to understand the interaction between regulation and investors' appetite for U.S. banking stocks, look at the highly regulated utilities sector, which is as boring and staid as banking is volatile.
The Dow Jones utilities index has almost tripled on a total return basis since 2004, since when the KBW Nasdaq bank index is up only about 40 per cent. Looking back a bit further the KBW index is up 300 per cent since January, 1995, not including dividends, compared to a 400-per-cent return for the Dow Jones utilities. Those lower returns in banks have come along with more volatility and steeper falls, or drawdowns.
Which is exactly the point: Investors know how U.S. banks are run when left to themselves, and hate it.
James Saft is a columnist with Reuters.