Many performance improvements can raise bank valuations. The most powerful may not be the ones you’d expect.
At a time of fitful economic growth, banks around the world have lacked one of the most powerful engines for performance and valuation: robust GDP growth in their home economies. That leaves managers scrambling for other ways to improve, largely via cost cutting, growth initiatives, risk-weighted-asset reductions, and portfolio rebalancing. Each of these can have a significant impact on a bank’s health, but they don’t all add value equally. How should a savvy bank executive set priorities?
One way is to gauge the impact of different metrics on bank valuation. We tested more than 60 metrics that banks might use to measure their performance, specifically examining the impact of different levels of performance on the market-to-book ratios of more than 80 European and North American banks. At the highest level, we found that many things bank executives might expect to affect their valuation, such as market capitalization, asset size, loan quality, and business mix, actually had only marginal impact once you control for return on equity.
In general, home-country GDP growth and forecast revenue growth can have a real impact on the price-to-book ratio. But they pale in comparison to many measures that contribute to returns on equity (ROE). By measuring the impact of improving ROE by one percentage point through a single measure, while holding all others constant, we found that changes in some components of ROE can drive bigger increases in valuation than others (Exhibit 1)—though it should be noted that the difficulty of doing so may vary substantially.
When considering which performance improvements to pursue, we found that the relationships between a bank’s performance relative to peers and valuation varied substantially. Some improvements had consistent impact on market-to-book ratios, while others did so only if a bank was at the top of the industry or getting out of the bottom.
Improvements to some metrics boost valuation for all banks
Performance in two areas improved ROE regardless of a bank’s ranking relative to peers. First, we found improving the size of the deposit base relative to assets to be a uniformly powerful metric; a bigger deposit base routinely results in a higher valuation. The data show that this is a very reliable driver of an improved market-to-book ratio.
A second powerful factor that drives bank valuations is the ratio of risk-weighted assets to total assets. A reduction in this ratio generates large and consistent benefits. What banks achieve here will have a much bigger impact on their valuation than any other action.
The clear implication is that banks should work continually to improve these ratios and periodically relaunch programs that deliver ongoing incremental improvements.
Improvements to other metrics boost valuation for the best and worst performers
Several performance improvements can have a substantial effect depending on current levels of performance. The scale of the valuation gain they offer is minimal unless a bank is either very strong or very weak at them. Banks that fall at either end of the performance ranking can improve their position relative to peers by focusing on three areas: fee income, revenue growth, and efficiency ratio (Exhibit 2).
The biggest gain to market-to-book valuation, even for banks in the top decile of performance, comes from finding ways to improve the ratio of fee income to total assets. Those that perform in the bottom third of rankings on this measure can also take advantage of an opportunity of similar scale. However, banks that fall in the area in between the top and bottom find little added valuation benefit from boosting relative performance incrementally. Although a bank CEO might aspire to top-decile status, it is likely that this would require a major shift in strategy and take substantial time to achieve.
Relative improvement to peers in revenue growth can also boost the valuation of a top performer. But for most banks, as long as the growth forecast isn’t negative, there isn’t much benefit to be found here—unless revenue growth can be pushed above 8 percent.
Finally, top performers that improve the cost-to-income ratio, also known as the efficiency ratio, also see a boost to valuation. Here the data show a pronounced benefit from not being in the worst-performing 30 percent of banks. However, for those above that level, there isn’t much of an impact until banks reach the top decile, where the efficiency ratio is below 50 percent.
Some improvements boost valuation only for laggards
Two other factors—the ratios of loan-loss provisions to revenue and equity to risk-weighted assets—only confer valuation advantages for banks if they currently lag well behind their peers (Exhibit 3). Above-average or outstanding
performance provides a marginal uplift to a bank’s rating.
Banks only benefit from improving their loan-loss-provisions-to-revenue ratio when they’re among the worst performers, that is, in the lowest decile. Once the loan-loss provision is less than 10 percent of revenue, further improvements may well be healthy for the bank’s profit-and-loss statement, but the benefit with respect to the price-to-book valuation is minimal. The value from improving the ratio of equity to risk-weighted assets is similarly minimal once banks reach the average level of performance (with the ratio below about 12 percent). Further gains don’t offer much potential to improve the market-to-book ratio.
Our findings apply to any bank, although some have more opportunity to take advantage—or more work to do in order to chalk up valuation gains. Market-based analysis can help them determine where to put their best efforts.