By James Saft
NEW YORK, April 4 For a business whose main
products fetch record prices, the financial services industry
sure is firing a lot of people.
That combination may illustrate why finance is a sector you
want to own, very possibly for the long haul.
Financial conditions are bank friendly; The stock market is
at or near all-time records and demand for risky bonds is high.
At the same time, announced layoffs in the financial sector are
up 37 percent in the first quarter compared to a year ago,
according to consulting firm Challenger, Grey & Christmas.
And while financial sector profits recovered somewhat last
year, they are still well below where they were in 2006.
However, the median compensation ratio, the percent of revenues
paid out to employees, among the 15 largest U.S. banks fell to
49.9 percent by the end of 2012, according to ThomsonReuters
First Call data, down from 56.6 percent earlier in the year.
Overall employment in the sector registered a net decline in
March, after several years of tepid recovery from the massive
falls in 2008 and 2009.
In short, financial services appears to be a shrinking
industry, but it is becoming one where net profits are rising,
something that benefits shareholders.
Here is a stylized summary of the experience of owning
banking shares over the past 15 years or so, to help illustrate
the disconnect between financial company shares and shares of
other industries: You wake up one morning and the bank in which
you own shares reports booming revenues. At the same time, the
bank's compensation outpaces earnings growth. Shares rise, but
not as much as they would if the bank made widgets.
Not many days later, you awaken to find your bank has
reported a terrible, unexpected loss, generated by trading or
securitization or some other oft-occurring 100-year storm. The
event crushes your shares despite protests from the CEO that
"controls are excellent."
This example illustrates why investors place a lower value
on a dollar of bank earnings compared to other industries. Those
earnings may be here today, but gone in a derivatives blow-up
The more reliable earnings are, the higher the price the
stock market gives for the company. Banks simply aren't that
In large part, that's because of how banking compensation
has encouraged insiders to take big risks and push complicated
products to clients. The rewards for employees are big, and
shareholders absorb the losses when things go wrong.
That risk profile may be changing, and tighter regulation is
playing an important role. While the regulatory system in the
United States is still deeply flawed, as evinced by the
too-big-to-fail subsidy enjoyed by the largest banks, the
general trend is toward stronger oversight, higher capital, and
in part as a result, simpler and less risky activities by the
To be sure, tighter regulation crimps profits. Banks will be
forced to hold more capital, which will reduce profitability.
There is also a real risk that the cost of that capital will
rise, at least at first, as many banks all seek to raise equity
at the same time.
But on the other side of the equation, tighter regulation
will very likely entice banks to offer simpler, less risky
products and employ simper strategies when they risk their own
The great advantage, from a shareholder's point of view, is
that the organization becomes easier to manage and control, and
one which needs fewer employees. Less of the revenue will walk
out the door in compensation, and banks will become less prone
This change at argues for two huge changes that will unlock
value for shareholders.
Earnings will become less volatile. Sure, banking will
always be cyclical, and banks will always have a difficult time
during downturns, but the risks of a London Whale-style blowup
should recede slowly over time.
As earnings become more reliable, the multiple that a dollar
of bank earnings can command on equity markets will go up. This
won't necessarily be a smooth process, but as banks become less
like casinos and more like utilities, investors will slowly
become more willing to pay more per dollar of bank earnings.
That's because they will become more convinced that those
earnings are more consistent and secure.
There are major risks to this scenario. Financial market
memories are notably short, and after a couple of good years it
is very possible that regulators ease up and banks and their
employees return to risk taking and overpaying themselves.
It is also very possible that it takes longer for investors
to get comfortable with the industry and the focus becomes the
lower revenues rather than the more predictable profits.
The most likely outcome is a slowly shrinking industry, with
perhaps lower revenues but more reliable profits.
It may not be pretty, it certainly won't be fun for
employees, but banking may once again become a good, long-term