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BLBG: Wall Street Finds a Good Kind of Leverage
(Bloomberg Gadfly) -- Europe's banks are exposed to a lot of political cross-fire this earnings season. This weekend starts a wave of elections across France, Britain and Germany that might reshape the European economy. U.S. President Donald Trump has financial regulation in his sights. These are unpredictable times.
CEOs won't have all the answers for investors. Too much is out of their hands. But one thing they can do is follow Wall Street's lead by sharpening up their moneymaking skills -- or improve "operating leverage," as the jargon has it.
In theory, it's a simple concept. The more you fix your costs, the more any extra revenue growth from an improving economy will go straight to the profit line. That's operating leverage. Bank of America Corp.'s Brian Moynihan mentioned it several times this week as he reported higher revenue, while BoA's expenses stayed flat and headcount and investment risk fell. Investors like that kind of thing.
In practice, operating leverage is hard to juice. Europe's banks have been squeezed on the profit side by higher regulatory costs and complex bonus structures and on the revenue side by negative interest rates. They've been slow to restructure. Top lenders' net revenue has fallen 5 percent since 2012, faster than costs, according to Bloomberg Intelligence's Jonathan Tyce. Pre-provision operating profit -- stripping out the benign effect of lower loan losses -- has fallen about 15 percent.
Bank bosses are trying to fix this as markets get more confident about rising interest rates in the U.S. and better economic prospects in the euro area. Some want to shrink more. Tidjane Thiam of Credit Suisse Group AG is trying to cut another 1 billion Swiss francs ($1 billion) in expenses while lifting revenue. Others want to reduce the drag from bonuses. Jes Staley of Barclays Plc said this year that his bank took an upfront charge of 395 million pounds on deferred-bonus accounting to improve operating leverage.
Another option has been locking in cheap funding at fixed rates, meaning any interest rate rises translate straight into profit. That's where central bankers have helped, not hindered. Euro-area lenders gorged on free four-year loans from the European Central Bank last month, taking 233.5 billion euros' worth. Italian banks UniCredit SpA and Intesa Sanpaolo SpA borrowed about 36 billion euros. If rates go up, that directly fattens the margins banks make from lending on those funds.
Obviously, much depends on rates rising in Europe. JPMorgan Chase & Co. analysts don't expect an ECB hike until late 2018 but note that short-term market lending rates, as priced by 12-month Euribor, are seen turning positive at the end of 2017. Optimism about rates explains why European bank stocks have risen 16 percent in six months. There could be disappointment but -- for now at least -- banks are under pressure to grab more revenue rather than just pare back.
Wall Street has lessons here for Europe. U.S. financial markets are in fine fettle, with trading revenues rebounding and interest rates rising. But not all banks benefited equally. Goldman Sachs Group Inc. underperformed while Morgan Stanley's more radical restructuring paid off. Simply waiting for rates to rise is no panacea. Bank of America has shown the way with a clear strategy: cut headcount, merge real-estate assets and put more staff in front of clients.
Europe's politics may be scary. But a firm grip on operational leverage would offer comfort.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Lionel Laurent is a Bloomberg Gadfly columnist covering finance and markets. He previously worked at Reuters and Forbes.