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Investor Insights – Banking: opening the black box

Investor Insights – Banking: opening the black box

Amid uncertain times, investors identify the key value drivers in banking.

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Lindsey Stewart

Senior Manager, Investor Engagement

KPMG in the UK

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Investor insights – Banking: opening the black box

Amid the COVID-19 crisis, the banking sector looks to be facing a level of turbulence comparable to that of the financial crisis of 2008. 

Governments are again starting to inject unprecedented quantities of liquidity into the financial system and – at the same time – the banking sector is facing short-term prospects of worsening credit quality, higher loan impairments and cancelled payouts to shareholders.

The KPMG Investor Insights team recently spoke to investors and analysts specialising in the banking sector – you can access the slide deck here. The conversation revealed some interesting points about what genuinely drives value in the sector, what the short-to-medium term outlook looks like, and whether there may be a greater role for audit and assurance in the future. 

ROTE learnings

There has been a relentless focus by bank CEOs on optimising return on tangible equity (ROTE) – with a particular emphasis on trying to generate returns above the cost of equity to deliver value for shareholders.

However, breaking the ROTE equation down in its simplest form – i.e. financial returns / tangible equity – there are a handful of important performance drivers on both sides of the equation that investors focus on.

Drivers of financial returns

Segment revenues: Our audience agreed that net interest margin for commercial and retail banking segments is of key importance, recognising that the low interest rate environment that has persisted for the last decade has suppressed profitability for many banks. Additionally, they noted that the revenues of investment banking segments were largely reliant on market volatility. It will be interesting to see whether – amid the extreme volatility of the first quarter of 2020 – investment banking proves to be a profitable buffer for some banks against worsening credit performance.

Cost-income ratio: Given the low margin environment, many banks have prioritised extensive cost control programmes – an area of frequent attention on the part of investors and analysts. Often when calculating cost:income ratios, banks’ normalised performance measures strip out significant expenses – e.g. conduct and litigation costs, restructuring costs, and redress costs for previous product mis-selling. Although it can be argued that these costs do not reflect the current underlying performance of the core banking business, our audience was keen to point out that these are real cash outflows – and ones that keep reoccurring – that are ultimately borne by shareholders.

Risk-adjusted losses: New accounting standards under IFRS and US GAAP have focused attention on expected credit loss impairment models – attention that has increased recently with all the signs pointing to a coming global recession. Investors will be keen to ascertain the size and timing of credit impairment provisions as new economic assumptions are applied to the bank’s credit models.

Drivers of tangible equity

Regulatory capital requirements: Regulatory capital is a complex area in which requirements frequently shift, which has raised both costs and challenges for compliance by banks. There are examples in the market of major issues with regulatory capital, leading to sharp share price falls upon discovery. This is also a challenging and complex area for auditors to provide assurance over.

Stressed losses: Investors are generally comfortable accepting the findings of prudential regulators’ stress tests; however, such tests are not subject to audit and would be difficult to provide assurance over.

Distributions to shareholders: dividend payouts (as well as share buy-backs) form a key element of the investment case for bank shareholders – and they are an area in which auditors can add value by assuring over realised profits and distribution capacity. However, regulatory capital is the real binding constraint over banks’ shareholder remuneration policies.

The investor perspective

It is interesting to analyse the way that investors break down ROTE into various influencing factors and quantitative indicators, which then feed into three principal valuation metrics.

Chart 1

Click here to view the full image.

A key question when it comes to valuing banks is why they tend to trade at a persistent discount to tangible net asset value. Our audience indicated that the market could be applying this discount for several reasons including:

  • the complexity of banks’ business models compared to other non-financial companies;
  • the difficulty successive management teams have faced in achieving profitability and return targets in the current low interest rate environment;
  • the regulatory environment for banks is constantly shifting, with increasing capital requirements;
  • the potential for negative surprises in areas of conduct and litigation.

A role for greater assurance?

One of the proposals in Sir Donald Brydon’s recent Independent review into the quality and effectiveness of audit, highlighted areas in which greater assurance could be provided over the metrics and disclosures issued by companies, particularly in investor presentations and stock market announcements. 

Our audience was keenly aware that many of the key drivers mentioned above are not within the scope of the audit at present – a fact that investors sometimes are unaware of. It was also noted that areas exist where auditors can – or already have – taken steps to provide additional assurance over segment revenues, cost:income ratios and normalised performance measures. However, such assurance can currently only be given if the auditor is engaged to do so by the company being audited.

Our audience noted that additional assurance might not be needed in some areas if company-defined metrics were reconciled back to audited statutory line items in the financial statements. This would appear to be in line with the thinking of the International Accounting Standards Board’s General Presentation and Disclosures exposure draft, which is currently open for stakeholder comment.

There was also general agreement that some areas of considerable importance to investors – e.g. Pillar 3 disclosures under the Basel framework, including risk-weighted assets – would prove very difficult (and costly) to audit due to a low level of standardisation and the complexity of banks’ internal models.

About KPMG Investor Insights

Our banking roundtable session with investors and analysts was held on 26 March 2020. It is one of a series of investor outreach events we hold to discuss and share perspectives on how corporate reporting, auditing and assurance, and stewardship can evolve to meet investors’ needs today and in the future. Visit our Investor Insights page to find out more.

© 2020 KPMG LLP a UK limited liability partnership and a member firm of the KPMG global organisation of independent member firms affiliated with KPMG International Limited, a private English company limited by guarantee. All rights reserved.

For more detail about the structure of the KPMG global organisation please visit https://home.kpmg/governance.

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