Saturday, April 1, 2023

Time to cut banker pay once and for all


Once was a bank, run by wokies
Didn’t hedge, now it’s brokies
A biased deposit base, ironic that
Time to pass around the hat

What a week. This time it’s different, but it sure feels like déjà vu all over again. Big moves in markets. Discount windows. I’ve taken to poetry to keep sane. My funds are bloodied. Yours too, I’m guessing.

The temptation “to do something” is overwhelming. Sell. No, buy! Put your cash in a suitcase. UK readers are also digesting a Budget unusually rammed with morsels. More on this next week.

The best approach is to keep an investor view. Relate each event to moves in asset prices. Where are valuations now? What is discounted? Weigh up risk and reward. Stay calm and analyse the numbers.

Let’s start with Silicon Valley Bank. Personally, I wouldn’t have given it a dime — preferring lenders with names such as Morgan or Rothschilds in them, or banks that sound like countries. A west coast bunch of start-up-loving bean bag sitters? No way.

Like many, including European regulators, I’m surprised at the generosity of the US bailout, not to mention the irony of it. These were the disrupters. They boasted of breaking things. One small crack, however, and they ran to mummy. In the UK too.

For investors, though, SVB and subsequent spasms are helpful in my view. I wrote last week that policymakers would eventually “bottle it” when it came to raising rates — too painful. But how to do so without losing face? The European Central bank went 50 basis points on Thursday, but dropped its hawkish stance. Others may follow.

Markets agree. For a brief while on Monday, futures were pricing in two 25 basis point cuts by the Federal Reserve this year. Only weeks ago, another increase was expected this month. No wonder bonds are flapping like geese in a gale. Ten-year Treasury yields have round-tripped by more than 100 basis points this week alone.

Yields are now lower across the board, which when the dust settles will comfort equity owners (wrongly, but there you go). And with inflation still around, real interest rates may have peaked for now. This helps traditional bonds and their inflation-protected cousins.

Meanwhile, bailouts, looser money and lifelines to the likes of Credit Suisse and First Republic will support bank shares in the short run. But lower net interest margins are ultimately bad for bank earnings. The sector is cheap, though, at 1.1 times book value.

And there are quality banks with price-to-earnings ratios barely in double digits. A counter argument is that stronger regulations and capital requirements are surely coming. Maybe. No doubt Wall Street rushed to deposit $30bn with First Republic in order to show it can look after itself.

As an investor I’d welcome a tad more intrusion — if not from regulators. To understand why, join me a dozen years ago sitting opposite Congressman Barney Frank at the White House Correspondents dinner. We were swapping financial crisis war stories while a senior banker showed us photos of his new yacht (clue: it’s probably rigged and ready to sail).

If you’d told Barney then what banks would look like now, he would have laughed. His Dodd-Frank Wall Street Reform and Consumer Protection Act had recently overhauled everything from consumer protection to derivatives trading. Change was coming. And yet banks are more or less the same today.

We knew there would be more crises. But at least everyone hoped section 951 of the law would make a difference. It gave shareholders a “say on pay”. If banks were essentially underwritten by the state, we thought, surely over time excessive wages would be forced down.

This hasn’t happened, either. If you take the 10 biggest US lenders, for example, average employee compensation as a percentage of revenues is four percentage points higher since the financial crisis than in the boom years preceding it, according to CapitalIQ data.

Shameless. But it explains why banks have tried their darndest to have us forget we bailed them out. Yet bankers are still remunerated as if they are owners or entrepreneurs taking personal risk.

Hopefully, the $300bn of Fed support this time round will remind everyone what nonsense this is. Especially shareholders, who have watched as employees at many banks line their pockets while suffering a below cost of equity return.

But I see this as a glass half full. Earnings multiples for banks are already tempting, as I showed above. They would be even more attractive if bankers were paid salaries and bonuses more in line with other professions, such as accountancy and law.

By my calculations — again for the US’s top 10 — reducing banker pay by just a third would increase net income margins and returns on equity by 10 and four percentage points respectively. For an industry with middle-office staff earning six-figure packages, a halving in compensation is more the ballpark I reckon.

This not only suggests an upside for shares, it would help remove moral hazard. Lenders know they are paid like rock stars when times are good, while idiot taxpayers pick up the tab when the stage lights explode, setting everyone’s hair on fire.

All of this means I’m very seriously looking at bank sector ETFs at the moment. I wrote about them briefly in January when shares were much higher than they are now. Anyone got any fund suggestions to share? If not, a poem?

The author is a former portfolio manager.; Twitter:@stuartkirk__

This article has been amended to correct the increase in ECB interest rates

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