In March, Fundsmith’s Terry Smith wrote that although he’d been a leading bank analyst, he would never invest in traditional bank shares. The numbers aren’t good enough. Look at NatWest (NWG), he said. For every £100 of assets, there was £5 of shareholders’ equity and £52 of loans. That meant that if a tenth of its loans went bad, the equity would be wiped out.
Admittedly, on the other side of the balance sheet in the Smith example, 65 per cent of liabilities were made up of deposits, but because they borrow short and lend long, all banks are vulnerable to bank runs. These are rare – banks can normally balance their books by borrowing from other banks. But not always. Liquidity evaporated in the 2008 financial crash, and the government ended up owning 83 per cent of NatWest (then called RBS).
To help survive the crash, banks boosted their capital by tapping shareholders. To inhibit systemic risk, they were made to disentangle retail from investment banking. That rendered corporate banking less efficient. Financial regulations were intensified, and since then a raft of consumer-friendly measures have come in, such as open banking, which allows competitors to poach customers seamlessly. During Covid, banks agreed not to foreclose on loans. Recently, the government asked them to refrain from repossessing properties with non-performing mortgages. They agreed again. Initiatives like these dent profits. Meanwhile, competition from fintech challengers (in deposits, lending and payments processing) chips away at the larger banks’ market share. Smith concluded that traditional banks are doomed to underperform the wider market – despite their leverage, their return on equity will always be lower.