Profitability, valuation and resilience of global banks - a tight link

Summary

Focus

Equity valuations signal investors' persistent concerns about some global systemically important banks (G-SIBs). For these banks, the price-to-book ratio (PBR) – the market value relative to the accounting value of equity – has been trending downward or has remained at deeply low levels over most of the past decade. A low PBR indicates investor scepticism regarding the bank's capacity to sustainably generate profits. Against this backdrop, we investigate whether profitability deficiencies can undermine resilience.

Contribution

We argue that there exist tight links between a bank's profitability, valuation and resilience. We derive this takeaway by focusing on 31 G-SIBs from 2014 to 2022. We measure profitability using return on equity (ROE), valuation with the PBR and resilience through the capital headroom above regulatory requirements ("management buffer"). We study the drivers of banks' PBRs. We also examine how PBRs shape G-SIBs' balance-sheet management, as these banks seek to simultaneously meet regulatory requirements and satisfy investor expectations. By estimating how the PBR influences investors' reactions to the announcement of an outsize loss, we obtain a sense of the challenges that a G-SIB would encounter when attempting to raise equity during periods of distress.

Findings

We find that profitability, valuation and resilience relate to each other in multiple ways. For one, a bank's PBR rises on the heels of a more favourable ROE forecast and an increase in the management buffer. These two factors, together with time-invariant bank-level characteristics, collectively account for almost 90% of the variation in PBRs. In addition, while high-valued G-SIBs pay out only a fraction of their earnings and grow their balance sheets, low-valued G-SIBs maintain their management buffers by reducing risk-weighted assets and cater to investors by distributing their entire profits. However, the resilience of low-valued G-SIBs could prove precarious as they frequently incur substantial losses that trigger significant negative reactions in the stock market.

Abstract

We derive a tight link between the profitability, valuation and resilience of global systemically important banks (G-SIBs). We measure profitability using return on equity (ROE), valuation with the price-to-book ratio and resilience through the capital headroom above regulatory requirements ("management buffer"). We find that price-to-book ratios increase in analysts' ROE forecasts and in banks' management buffers. We also document that low-valued G-SIBs maintain management buffers by reducing risk-weighted assets and cater to investors by paying out their entire profits. However, the resilience of low-valued G-SIBs could prove precarious as they frequently incur substantial losses that trigger significant negative stock-market reactions.

JEL classification: G21, G28, C25

Keywords: financial stability, price-to-book ratio, banking regulation