There is a latter day curse victimizing financial institutions. That is to be recognized by the regulator as a “Systematically Important Financial Institution” (SIFI) In other words one regarded by the regulators as being “too-big-to-fail”. Hence the requirement by regulators of any SIFI of very strong balance sheets that ensure against failure. This translates into ample highly liquid assets on the asset side of the balance sheet that yield minimum income for the bank. Such safe assets will have to be accompanied by secure funding in the form very long dated liabilities that may be expensive to raise. It may be required that such debt be converted at very short notice- to be given by the regulator- into equity – should solvency come under serious threat. Such unfavourable terms for debt holders would add further to the cost of such funding . Furthermore short term liabilities that can be withdrawn at the whim of lenders, for example deposit liabilities,do not qualify as desirable secure forms of funding. Regulators then require of banks good cover in the form of capital and holdings of cash or near cash to be acceptable sources of bank funding. These requirements make short term deposits a much more expensive source of funding for banks.
The problem with such safe guards and fail-safes is that they must all come with reduced returns on the capital subscribed by shareholders in any SIFI. Less risk forced upon borrowers and lenders (higher costs of raising funds and lower rewards for allocating them) translates inevitably into less profitable financial businesses with diminished prospects for growth. These lesser prospects for shareholders immediately subtract from the long term value of any bank or financial business to its shareholders. Such is the curse on shareholders. It is also a curse on potential borrowers from a financial institution. It means less appetite by banks to lend even at higher charges and to much slower or negative growth in their loan portfolios.
South African banks are also having to face up to additional constraints on both sides of their balance sheets imposed by the international bank regulation convention known as Basle 3. This means significantly increased costs for banks raising funds and reduced returns on shareholder capital they risk. It must also mean both more expensive bank loans and fewer borrowers qualifying for them. It is not a formula designed to facilitate economic growth for which bank credit is an essential ingredient.
One way to break the spell over the SIFI is to reduce the scale of your financial activities – that is for a financial institution to become as systemically unimportant as possible- something shareholders will welcome and the regulators cannot easily stop, as General Electric (GE) is now in the process of doing. GE announced the disposal of USD26b of its real estate assets and property lending to the Blackstone Group and Wells Fargo last week, the first steps in winding down its Financial Division. GE’s intention is to dispose of USD200b of property and financial assets and associated liabilities under its control. GE Capital accounted for 57% of GE earnings in 2007- pre the Financial Crisis – and this contribution is planned to decline to 10% of earnings in 2018. GE has also announced that ; USD50b of the asset sale proceeds will be used to buy back shares equivalent to about 17% of its current market value while it intends to maintain its dividend –another means to return excess cash to shareholders.
The share market reacted very favourably to the news, adding nearly 14% GE’s share price and as much as USD37b dollars to its market value almost overnight. (See below) Perhaps also worth noting is that despite the recent jump, a GE share is worth but half of what it was in 2002.
Clearly exiting its SIFI status can be a market value adding move something the shareholders in SIFIs everywhere will not fail to notice. Reducing the size of GE and prospective earnings from the financial division, while releasing capital for prospectively superior returns, inside and outside GE has already added value for GE shareholders. Making the additional point, if it needs to be made, that it is not earnings per share or the growth in earnings per share that matters for shareholders, but return on capital, especially improved returns on reduced capital employed, that can add to the value of a share.
An unknown to the market is to what extent such downsizing to avoid an unwelcome, “too-big-to-fail” status, will give pause to the regulators. Or will the growth of alternatives to banks (in the form of more profitable shadow banks and other lightly regulated lenders) encourage them to further extend their regulatory reach at the further cost of shareholders and borrowers? An alternative, less regulation intensive and profit destroying approach would be to recognize the possibility of financial or business failure, of even the largest financial institutions. Such failure would have to be accompanied with severe penalties for shareholders and also debt holders of failing institutions. A credible threat of failure with its highly wealth destroying consequences for equity and debt holders will restrain risk taking in the first instance. But in the event of failure it will need well designed bankruptcy procedures, known in advance by bankers and central bankers, to limit the potential collateral damage to soundly managed competitors. The Global Financial Crisis was not only a response to excessive risk taking – encouraged it should be recognised by US government interventions in the market for mortgages. It was aggravated by the lack of clear procedures for winding down or supporting financial failures. Fixing this failure is a better approach than regulations that attempt to eliminates both the risks of failure but also and the returns and the benefits to customers that come with taking such risks. The rewards of success, because of the risk of failure is the essential raison d’etre for any business enterprise including financial businesses. Denying the trade off between risk and returns will eliminate both as well as all potential SIFIs that have so much to contribute to any successful economy .