Banking Law

Another guest post by John M. Walker, Jr. He risks sounding rude, arrogant and condescending, which, if he does, would put him in good company.

Housing Wire noted yesterday a report is to be issued by JPMorgan analysts who have calculated that, ?if the full burden of regulatory and political initiatives to crack down on banks? risks is implemented, it would cut the average return on equity from a projected 13.3% to 5.4%.?  No fake ? why would that result come as a surprise to anyone ? other than politicians, that is?  Simple financial math explains why that?s the case.

Return on equity (ROE) reflects the link between a business?s income statement and balance sheet and highlights the interconnected relationship among revenue, net profit, assets, and common equity.  In addition to the simple equation ROE = Net Profit ¸ Common Equity, ROE also = Margin x Asset Turnover x Financial Leverage; and, since Margin x Asset Turnover = Return on Assets (ROA), ROE also = ROA x Financial Leverage.[i]  Changes in one or more of the constituent components will change ROE ? and, since one of the political/regulatory initiatives is to require more Tier 1 capital (which primarily is equity) be held by banks, financial leverage necessarily will decrease and, if margin and/or asset turnover somehow also aren?t increased, that is, if ROA also doesn?t increase to offset the decrease in banks? financial leverage, ROE necessarily will decrease.  Mathematically, it must.

Let?s look at a simple illustrative example (all numbers are in $ millions and are taken from an actual bank?s 2008 financial statements ? 2009 isn?t available yet):  a bank with annual revenue of $41,897, net profit of $2,369, total assets of $1,309,639 at the end of the year (EOY) and $575,442 at the beginning of the year (BOY) for an average total assets held during the year of $942,540.5 (to calculate returns for the year, total assets and common equity typically are averages of the BOY and EOY balances in order to determine the capital invested in the business during the course of the year), and common equity of $99,084 at EOY and $47,628 at BOY for an average common equity of $57,465.  These numbers translate to a margin of 5.65% ($2,369 net profit $41,897 revenue), an asset turnover of .0445 (revenue of $41,897¸ average total assets of $942,540.5), financial leverage of 16.4020 (average total assets of $942,540.5 average common equity of $57,465, a ROA of .25% (margin of 5.65% x asset turnover of .0445), and a ROE of 4.12%, either by dividing net profit ($2,369) by common equity ($57,465) or by multiplying margin (5.65%) times asset turnover (.0445) times financial leverage (16.4020).   If the bank?s capital requirements had been such that it?s financial leverage had been, say, 12.50 (which would be the case if the common equity were 8% of the institution?s total assets), and margin and asset turnover had not changed (meaning ROA had stayed at .25%), ROE for the bank would?ve been 3.13% (ROA of .25% x financial leverage of 12.50).  To maintain its ROE at 4.12% in light of the reduced financial leverage, ROA would?ve required improvement to .33%; and an ROA of .75% with a 12.50 financial leverage would?ve resulted in an ROE of 9.34%.  If the financial leverage had been 10.00 in my example (common equity at 10% of total assets), then the resulting ROEs would?ve been 2.50% (if ROA had stayed the same), 4.12% (requiring ROA to increase to .412%), and 7.50% (if ROA had improved to .75%). Feel free to play with the numbers to your heart?s content.

Let?s move away from the math for a moment and look at an important element involved in the investment of capital and its possible impact on bank performance and bank ability to raise capital:  the greater the risk, the greater the reward potential; the lower the risk, the lower the return likely is to be. Investment capital flows to returns; that is, it moves toward higher returns and away from lower returns if the risk is perceived acceptable in both cases to the investor.   Tying this back to the math:  assuming that there are new costs for banks related to new regulatory compliance and assuming further that reduced risk-taking that may be imposed on the banks results in less ?reward? to the banks for those permitted activities, it?s entirely possible that ROA also will decrease, as opposed to remaining constant or improving.  If that happens ? a new banking business model that incorporates a reduced ROA and a reduced financial leverage ? banks likely will earn less ROE than historical performance has led the investing public to expect.  I guess that?s what the JPMorgan analysts' report will show.  If that is in fact what banks do experience, they will have a difficult time attracting equity capital, as investors will seek alternative investments providing higher returns; and, that inability to attract equity capital well may reduce further banks? ability to engage in banking activities such as making loans at desired levels.

Bet that?s not a consequence intended by the Administration, Congress, or the regulators ? unless they?re trying to chase private equity capital away from the banking industry.  But, that?s what happens when solutions to business problems are made for political ? and not business or economic ? reasons.  As I said in a recent guest posting on this site, politicians focus on positions, not interests, when trying to solve problems.  And, we end up paying the price for the unintended consequences ? again and again.