Sir,
We agree with Andrew Hill (“Shocks from the Rock have pushed us into the mire”, Lombard, December 14) that we need to “explore a way back to the high road”. But we disagree completely that the principal issues are “Who owns the Northern Rock?” or “How should the Tripartite Authority be amended?” And we cannot share his hope that “clever people” show the way. Rather we think the way forward is all about rebuilding shareholder value by addressing the fundamental drivers of value.
There can be no doubt that we have experienced a “golden age of banking”. Our analysis shows that the market value to book value (MV/BV) for European banks almost doubled between 1994 and 2006 (from the range 1.0 to 1.5 to the range 2 to 3). But banks have lost favour in 2007. On average there has been a reduction of some 30 per cent in MV/BV ratios.
This average hides a range: some institutions have proven resilient (eg BCP, Bankinter, Banco BPI, Lloyds TSB and Banco Popular Español) with an MV/BV reduction of less than 20 per cent, while others have been harder hit (eg HBOS and Crédit Agricole have suffered a 40 per cent decline; Alliance & Leicester and Bradford & Bingley have declined about 50 per cent).
But how to reverse this trend? The message is simple, if unexpected. Enlightened institutions will start by trying to bear down on the required rate of return. Surprisingly, a 10 per cent reduction in required return will actually have more impact for most banks than bolstering return on equity by 10 per cent. A large component of the required rate of return is the risk-free rate and institutions have no influence over this. They are “environment takers” in this respect. But they can influence the required risk premium.
In part this will entail broadening their thinking on risk: most of banks’ efforts are currently directed at reducing specific risk – but it is undiversifiable risk that drives their required rate of return. Reducing undiversifiable risk requires taking a fundamental look at the balance of the business portfolio and a view rather different from that taken by Chuck Prince, former Citigroup chief executive. “As long as the music is playing, you’ve got to get up and dance,” he told The Financial Times, adding, “We’re still dancing.” Clearly the market rewards those who stop dancing rather earlier.
Mark Thomas, Richard McManus
PA Consulting Group
London SW1W 9SR
