By JAMES SPENCE
Banks are an easy exclusion from the Global Leaders remit. Easy on account of the fact they fail three critical tests for inclusion.
Banks are leveraged, banks are complex, banks are not truly global.
The portfolio as a whole has a current debt to equity ratio of 0.3 (or 30%). Taking an onaverage capital base of 8% equity, banks are inherently leveraged. If we consider the rest of banks’ balance sheet to be in the form of leverage, a conventional calculation would yield 11.5x leverage. That means that banks are, on average, 38x more leveraged than the average of invested Global Leader companies. If banks held to the leverage parameters of our holdings, they would earn a Return on Equity of less than 1%. De-natured from their economic purpose, banks equity would have to be supplied by their home market government, as they are sometimes forced to do.
The pertinent risk here is that banks do not necessarily have holding power to survive deep economic cycles. Being the inverse of economic activity – banks’ debits being companies’ and individual credits – they suffer disproportionately despite holding collateral.
Banks are complex in two ways: the diversity of their operations in wholesale, retail and merchant banking activities and then also in their opacity. This tendency to opacity is not willful but more the consequence of aggregation. For, when a bank publishes its balance sheet, everything within may be accounted accurately but the risks are often difficult or impossible to discern.
There is an enormous contradiction inherent in banks in that they are charged both with taking risk and managing risk. The awkwardness of this paradigm lies within the question of whether these skills should reside within individuals or be separated by departments. The legendary bankers of yesteryear: from the Rothschilds and the Warburgs to John Pierpont Morgan all had something of both natures fused within them. As banks have got larger and their operations more dispersed, their CEOs have less ability to define both sides of risk.
The final aspect is their geographic remit. Whilst some banks do have operations all over the world: Santander, HSBC, BNP Paribas, JP Morgan being examples, when trouble looms their main recourse is to their home market regulator and Treasury. This, to our minds, matters a great deal more than the headquarters location of a non-banking corporation.
In certain contexts, particularly Emerging Markets, banks have operated as consumer proxies for equity managers looking to build out their portfolios. This approach looks forced and unsurprisingly the managers of Cerno Pacific do not have banks as part of their remit either.