return on equity

A friend of mine pointed me to research by analysts at JP Morgan who have developed a ‘doomsday scenario’ for the banking industry that assumes all current regulatory suggestions and then calculates their impact on profitability. It doesn’t take much imagination to see that the return on equity will be massively reduced: not only are the banks limited in what activities they can generate profits from, but their ability to ramp up leverage would be significantly reduced also. It would be the perfect storm of profitability reduction.

Which is a good thing.

And exactly what I would hope happens.

The curtailment of ROE opportunities in finance would force investors to search elsewhere for profitable places to deploy their capital. As a society we need this result. As long as the returns offered in finance are higher than those in the ‘real economy’ capital will disproportionately flow into the banks, and away from activities like manufacturing where new jobs could be created. So slashing bank returns is a good thing for the rest of us, although bankers whose bonuses would suffer probably will object.

The research also supports my point made a couple of days ago: banks are conglomerates of businesses with a melange of ROE’s that average out to whatever we see reported in their financial reports. If bankers were truly upset over the drop in their overall ROE’s they could break their banks up and expose the range of returns within the prior conglomerate. Some of the new and smaller banks would have very high ROE’s and could still attract capital. Others would be exposed as loss makers that need either to be closed up or managed back to health. This transparency of returns is socially beneficial in that capital can then be allocated by the market to better opportunities. Right now capital going into our banks gets allocated internally and a process that may not be efficient. All the evidence of the last two or three years tells us that bank mangers are very poor at capital allocation: they poured money into activities that generated huge losses. They should not trumpet their ability to allocate capital – they lack one.

Everyone except the bank managers benefits from the regulation the JP Morgan analysts decry. Yes bank returns would drop. That’s good. We need the capital is more useful places thank you. Plus those low returns might actually inspire some real innovation amongst our banker friends – innovation that creates profits that are more sustainable than the gambling they currently rely upon. Shareholders would benefit from breaking the banks up since the range of ROE’s they could choose from would expand thus allowing them to match their own risk/return requirements instead of having to rely on the faulty judgement of bank managers. Customers would also benefit since the smaller banks would be more focused on individual lines of business in which they have to find profit: this would spur innovation and competition, which would result in higher values for customers. Those faux innovations could become distant memories.

We can dream can’t we?

Remember lower ROE’s do not mean lower profits. The banks will still make big profits, but because their leverage is much lower those profits will represent less ROE. We need lower ROE’s to force capital away from the banks and into industry. So the larger message is that lower bank returns on equity are a good thing.