Research

Banks are emphasizing core strengths and cutting businesses that offer limited prospects for acceptable returns

By James Langton |

Big U.S. banks still need to cut costs and streamline their operations as returns on equity for some of them continue to lag the cost of equity capital, says Fitch Ratings.

The rating agency reports that it calculates the average ROE for the top six U.S. financial institutions (JPMorgan Chase, Citigroup, Bank of America, Wells Fargo, Goldman Sachs, and Morgan Stanley) was 9.0% during the fourth quarter of 2012, which is significantly below the calculated average cost of common equity for that group (11.8%).

However, it notes that within the group, ROE performance varied greatly, with Wells Fargo, JPM, and Goldman all reporting adjusted ROEs that exceeded the estimated cost of capital.

In the year ahead, it expects the weaker performers will continue to gradually narrow the gap between their ROE and their cost of equity capital. "Weaker earners will continue to reduce legacy costs and exposures, de-emphasize lower return products, enhance customer profitability, and continue to seek operational efficiencies," it says.

Still, it says returns exceeding the cost of capital may not be achievable in the near term for some major U.S. banks, "as legacy issues remain a large drag on consolidated results." For the higher rated banks, it says they "will likely continue to enjoy a significant advantage in ROE generation as 2013 progresses, allowing them more flexibility to build capital internally while distributing significant amounts to shareholders."

"We continue to expect many banks to reduce exposures to products and business segments that do not offer risk-adjusted returns commensurate with a bank's cost of capital, factoring in the impact of business improvement and operating efficiency initiatives. In particular, certain trading products and positions, such as structured and non-investment-grade exposures, as well as higher risk lending and counterparty relationships, may no longer achieve profitability targets on a risk-weighted basis," it says.

Fitch says that, in this environment, "banks are emphasizing core strengths and actively downsizing businesses that offer limited prospects for acceptable returns. For some, that means renewing their focus on fixed income, while reducing the scope of their equities business. For others, where the equities business is the traditional strength, the opposite is taking place."