Financial stocks are set to fly as we recover from the pandemic
The banking and insurance sectors are probably the world’s least popular apart from coal mining, says Jonathan Compton. The industry may face pervasive change, but the stocks look too cheap
Even hermits have heard of the collapses of Australia’s Greensill Capital, named after its founder Lex Greensill; America’s Archegos Capital (named from the Greek word for “leader” by its founder, Bill Hwang); and Germany’s Wirecard AG – a tiny casualty in the 2000 dotcom crash, then recapitalised in a reverse takeover by its CEO, Markus Braun.
Each of these men was a middle-management unknown claiming to have reinvented arcane areas of finance using new technology – which no-one questioned – to create eye-watering profits. Each was a consummate networker whose smooth sales patter attracted influential names from politics and business, creating a snowball effect. And each was leveraged to the hilt.
What intrigues me most is why some of the largest and theoretically most savvy banks in the world lined up to shovel ever more money into gaping black holes. This incompetence will do little to change the perception following the 2008 crash that banks and finance companies are unreformed gamblers. Yet despite these losses and rapid change throughout the sector, the investment case for banks is compelling.
Still too big to fail
After the 2008 meltdown in the global financial system the mantra was that no bank should ever again be “too big to fail”. In reality the big boys are still gobbling up the weak. A maximum of five banks dominate in every country. America is about to witness a frenzy of banking takeovers. Small challenger banks, sponsored by governments, were meant to shake up the market by taking on the established players. The UK is a leader in this regard, as well as in “fintech” – tech-driven financial services.
But these developments haven’t dislodged the dominant banks. This is a sector predisposed towards producing big beasts. In finance, size brings advantages, spreading costs and providing economies of scale in technology and compliance. The largest challenger is Virgin Money, an agglomeration of unloved banks whose assets are worth about 7% of those held by the UK’s No.2, Barclays. The assets of all challengers and fintechs amount to less than the Nationwide Building Society’s; it is the seventh-largest traditional bank.
Attracting customers with special offers is easy; making them profitable is not. Nor are the challengers cleaner than the behemoths. Metro Bank in 2018 was found to have mis-classified loans, thus breaching capital adequacy rules while the then-chairman had paid his wife’s firm at least £20m for design work on hideous colour schemes. N26, Germany’s largest online challenger, has been told by the German financial regulator, BaFin, to improve its IT systems to prevent money laundering.
Lex, Bill and Marcus highlight yet again the incompetence of the regulators and ineffectiveness of new regulations. So large and cumbersome are these (more rules were created between 2009 and 2015 than in the previous 200 years) that, perversely, it makes them easier to avoid. In the case of Wirecard, BaFin, the government and the Bundesbank threatened to prosecute the journalists who lifted the lid on its fantasy accounts.
Banks will always be unstable because of the genuine genius of fractional banking. Early bankers realised that depositors were unlikely to withdraw their money simultaneously, so only a fraction of deposits are backed by cash. The excess deposits are then used to lend, invest or speculate. Fractional banking is always at risk from a sudden loss of confidence, worsened by stupid loans or borrowing from the wholesale markets (in other words, other financial institutions), which can suddenly cut off credit. This helped bring down our introductory trio and, earlier, Northern Rock. Yet banking is changing at breakneck speed. The consequent uncertainty is one reason why many banks are dirt cheap.
Fintech is finding its feet
New tech-savvy competitors are one threat. Even at the turn of the century banks were wedded to the one-stop shop model, cross-selling a range of financial products. It never worked because the products were often poor and overpriced. New tech disrupters, sometimes selling a single product, have stolen much bread-and-butter business. Wise, for instance, founded in London in 2011, is an international money-transfer company. Its first-year turnover was £8m. Last year sales reached £4bn – per month.
Similar firms are murdering the high-fee, low-service foreign-exchange business of mainstream banks. Six-year-old Revolut is solely a tech-bank. It offers many financial services, is expanding overseas and already has an estimated 16 million customers. These new companies specialise in providing user-friendly and instant access via mobile phone or tablet, keen pricing and transparent fees. For anyone with any technical nous and anyone under 45, transferring money, or buying insurance or shares with lengthy paperwork at the branch of your local bank, is anathema.
The technology problem is also internal as most banks underinvested for decades. As a result, every takeover leads to a collapse in their computer systems. Having been bought by Spain’s Banco Sabadell in 2015, TSB’s future was destroyed in 2018 by a botched IT “migration” costing over £200m in reparations. Sabadell has forlornly sought a buyer, but has no chance of recouping its £1.7bn purchase price.
Yet the greatest threats to incumbent banks lie elsewhere. The core business of banks remains lending out their depositors’ money. The key metric in this respect is the “net interest margin”, or NIM, the difference between the interest rate paid on deposits and the rate charged for loans. With near-zero interest rates and fierce competition, NIMs are tight; witness the many sub-inflation mortgage offerings.
Worse, shadow banking has taken away much of banks’ core business. Providing finance for projects was once the exclusive preserve of banks. No longer. Non-bank finance and shadow banking is not dodgy geezers offering loans in cash, but rather pension funds, insurers and private-equity groups putting their spare money to better use. So my local solar farm, for example, was financed by pension funds and has been bought by an insurance company that needs a reliable income stream. Another major threat to banking is digital currencies. Cryptocurrencies’ underlying technology – blockchain, the digital ledger – is of potentially enormous value in terms of speed, security and traceability.
Central banks and governments have belatedly realised that they are potentially losing control of money and payments systems, not to crypto bandits, but to foreign giants and non-banks beyond their remit, such as Amazon or Google. Big Tech is seeking to develop blockchain technology; no wonder, then, that the major central banks are urgently looking into “central bank digital currencies”, or CBDCs (see page 16). These are hugely controversial, as potentially the blockchain allows governments to be aware of – or stop – your every financial transaction (hence China is trying to develop CBDCs as fast as possible), while in theory making the prime raison d’être for banks – taking deposits – more redundant than steam trains.
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