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Full year results for 2010 mark an interesting turning point for the global banking sector. With implementation of several changes under Basel III (BIS III) looming, higher capital, risk weights and liquidity requirements are leading to a secular reduction in return on equity (RoE). Management’s responses to this are being increasingly revealed. Here’s what to look for.

Over the last decade, banks have been generating high teen or even low twenties RoE. This was accomplished through changes to both the ratio numerator and denominator - higher revenue generation despite declining net interest margins, and, more importantly, lower equity capital. Revenues were driven higher through faster loan growth but more importantly, through growth of non-interest income. While total capital ratios edged downward only slightly, capital mix changed substantially, with equity capital increasingly being replaced by hybrid capital instruments.

BIS III not only reverses this equity capital trend, but has raised minimum capital levels as well (see discussion here). New, higher risk weights that are also applicable to more of the trading book are adding to the capital required. Revenue is also under pressure. Loan growth is currently muted and margin pressure continues in emerging markets. The recent crisis has reduced the opportunity for non-interest revenue generation in profitable, exotic products. Two exogenous events may mitigate some of this downward pressure: increases in interest rates depending on asset-liability structure; and continuing reduction in loan loss expense as permitted by economic growth trends.

Bank managements response to this can come on three operational fronts. Revenue generation will focus on stabilizing and/or increasing lending margins, and seeking out services where fees can be generated or increased. The opportunity for new structured product development seems limited in the near-term. Cost reduction initiatives will return as a focus, reversing trends of de-centralization and ad-hoc expansion. Finally, balance sheet composition and growth will be carefully considered in risk-weighted assets terms and RoE.

HSBC’s (HBC.A) 2010 full year results neatly encapsulate some of these trends. Revenues increased barely 2% aided by hedge gains and insurance premiums. Lending margins contracted 26bps over the previous year driven by emerging market trends. Loans to banks and customers grew 8%, but trading assets declined 9% and risk weighted assets contracted by 3%. Core Tier 1 capital increased to $133bn, pushing the core Tier 1 ratio to 10.5%, ahead of current BIS III requirements ... While it has recovered significantly since 2008, reported RoE was 9.5%. During yesterday’s earnings call, management announced continued focus on risk-weighted assets and cost reduction initiatives to reduce the cost-income ratio. Guidance on RoE is now 12% - 15%, lower than what the bank achieved in 2006 and 2007.

The market reacted negatively to HSBC’s results and updated guidance. However, HSBC management is outlining a more realistic expectation for the bank and the sector broadly going forward. This is an eerie echo of their accurate warning of worsening US consumer mortgage losses in their Q3/2007 trading update. Implications for other banks, particularly developed market banks, are clear – returns have shifted lower on a secular basis. Adjust valuation metrics to account for this shift.

Source: Are High Bank RoEs a Relic of the Past?