On Wednesday, the International Monetary Fund (IMF) named nine large financial institutions it predicted will struggle over the next few years to remain sufficiently profitable based on forecasted earnings for 2019. Insufficient profitability was defined as a return on equity capital (ROE) of less than 8 percent.
The IMF considers an 8-percent ROE as “a conservative estimate of investors’ required returns.” It characterized banks with ROEs below 8 percent as “weak” and banks with ROEs between 8-10 percent as “challenged.”
{mosads}The nine struggling banks the IMF named are a subset of 30 international banks the Financial Stability Board, an international financial regulatory body, has deemed to be globally systemically important. Citigroup was the only U.S. bank in the group tagged as struggling. Seven other U.S. banks in the group were forecast to be sufficiently profitable.
According to the IMF report, the Global Financial Stability Report for 2017, the 30 banks hold more than $47 trillion of assets, a sum representing over one-third of global banking loans and assets. The IMF fears that problems in even a single one of these institutions could generate systemic stress.
The other eight banks facing profitability challenges include two U.K. banks (Barclays and Standard Chartered), three European banks (France’s Societe Generale, Italy’s UniCredit and Germany’s Deutsche Bank) and three Japanese banks (Sumitomo Mitsui Financial Group, Mizuho Financial Group and Mitsubishi UFJ Financial Group).
To some extent, the profitability problems the nine targeted banks face are the lingering effects of longstanding issues dating back to the last financial crisis, rather than the onset of more recent problems. While none of these banks are facing eminent failure, the IMF said regulators should press their financial institutions to strengthen themselves by resolving non-performing loans and dropping unprofitable lines of business.
Although Citigroup is well-capitalized and preparing to return excess capital to its stockholders, its quarterly ROE has only twice exceeded 8 percent since the financial crisis, including the third quarter of this year, according to an earnings report Citigroup issued earlier today.
The three Japanese banks have long had weak earnings, reflecting both broader problems in the Japanese economy, Japan’s years of sluggish economic growth and the unwillingness of the country’s banking regulators to force the banks to deal aggressively with non-performing loans. Of course, doing so would force broader industrial restructuring in Japan, which could be quite painful.
Unicredit’s problems reflect weaknesses in the Italian economy exacerbated by Italy’s weak insolvency laws and prolonged delays in foreclosing on delinquent property loans.
One questionable assessment in the report is the excessively rosy outlook it paints for China’s four largest banks, with each of those banks forecast to have an ROE in 2019 exceeding all the other banks in the group of 30 globally important banks.
Those high ROEs are largely attributable to the banks materially under-reserving for losses on nonperforming loans. When China’s banks will begin to realistically account for loan losses is anyone’s guess.
According to one news report, the IMF said regulators should press their financial institutions to resolve nonperforming loans, drop unprofitable lines of business and develop plans to unwind the bank in case of failure. The IMF’s advice to banking regulators will likely continue to be ignored in Italy and China.
Even in cases where the regulators are not too aggressive with banks with low ROEs, those banks will be under increased pressure from investors to boost their ROEs while returning some of their equity capital to investors through increased dividends and share buybacks.
In order to meet regulatory capital ratios, though, banks shrinking their equity capital also will have to reduce their total assets. Downsizing a bank, though, will not automatically boost its ROE — only good management can accomplish that.
The downsizing of weak banks also will have the macroeconomic benefit of eliminating excess capacity in banking, notably bank branches. Merging weak banks into stronger ones also will slim excess capacity and should lead to greater efficiency and higher ROEs for the remaining banks.
How soon all of this will occur at the nine underperforming banks identified by the IMF is anyone’s guess. Hopefully it will happen at all of them before the next financial crisis hits.
Bert Ely is a principal of Ely & Company, Inc., where he monitors conditions in the banking and thrift industries, monetary policy, the payments system and the growing federalization of credit risk.