Banks' returns come back to earth, maybe for good

By Olesya Dmitracova - Analysis

LONDON (Reuters) - A slump in lucrative structured finance business and regulators' demanding bigger capital reserves mean stratospheric profitability at banks is gone, possibly forever.

The credit crunch has hammered the return on equity (ROE) of many banks, particularly those in Europe and the United States, since the second half of 2007, and those returns may never recover to pre-crisis levels.

"Will the fantastic returns of 2006-early 2007 come back? It's really doubtful. It was a unique environment where each and every asset class appreciated so it was very difficult to do anything wrong," said Bernd Ackermann, an analyst in rating agency Standard & Poor's financial institutions group.

In 2006, the top 10 banking ROEs ranged from 23.9 percent to 35.5 percent, with the average ROE at 13.6 percent, according to the Boston Consulting Group.

"Much of that (ROE levels) relates to capital ... what equity will be required in the next cycle," said David Fanger, an investment banking analyst at rating agency Moody's.

Last year -- split neatly into a record first half and a sharply slowing second half -- banks' after-tax profits fell for the first time since 2003 and their average ROE declined to 13 percent, but that was propped up by exceptional returns at some banks, mostly from emerging markets.

"Until last year, we'd had a 25-year run of low interest rates, excessive liquidity, particularly post-9/11, low inflation and relatively good economic growth," said Neil Dwane, chief investment officer in Europe for RCM, an investment unit of German insurer Allianz (ALVG.DE: Quote, Profile, Research, Stock Buzz).

REGULATION, REGULATION, REGULATION

Regulators will require banks to set aside more capital than before for risks other than that of default, such as potential losses due to a credit rating agency downgrade or due to a change in the price of an equity instrument.

"Does that permanently diminish ROEs? It may very well," Fanger said.

The high ROE levels enjoyed by banks in 2006-07 are gone for good, Dwane said. "In two-three years these businesses will be regulated and as exciting as utilities."

Large banks across the world, such as Merrill Lynch (MER.N: Quote, Profile, Research, Stock Buzz), UBS (UBSN.VX: Quote, Profile, Research, Stock Buzz) and Citigroup (C.N: Quote, Profile, Research, Stock Buzz), and other financial firms have written down $408 billion since the crisis hit, pressuring their ROE, a key benchmark for shareholders to measure profitability.

UBS's and Citigroup's ROE dipped into negative territory this year, compared to high positive returns last year. JPMorgan analyst Kian Abouhossein estimates that measure next year will still be considerably below the pre-crisis levels, or around 20 percent for UBS and around 11 percent for Citigroup.

According to S&P, Goldman Sachs (GS.N: Quote, Profile, Research, Stock Buzz) posted ROE of over 30 percent in 2006. JPMorgan sees that figure at around 19 percent by the end of 2009.

ROE reveals how much profit a company generates with the money shareholders have invested. It is defined as after-tax profit divided by total equity -- so the higher the percentage, the more profitable the company.  Continued...