When will banks be investable again?

Amid all the hand-wringing over how to make banks safer, one fact often gets lost: A bank's first line of defense is its ability to raise private capital. When a financial institution gets into trouble, investors should be on standby to recapitalize it if needed. Their quid pro quo: a satisfactory investment return.

The problem is that since the global financial crisis, bank equity has not been a terribly attractive investment. In Europe, banks' annual return on equity sagged during the sovereign debt crisis and recovered to only 6%-7% in the run-up to the pandemic. While returns are structurally lower than they were before the crisis as leverage declined, they remain below the level expected by investors for the risk they take. Since 2008, the average euro-area bank has been unable to earn the sector's cost of equity, according to the European Central Bank,

Such low profitability is reflected in lousy valuation multiples. Having traded at a premium to book value before the financial crisis, European banks have since traded at a persistent discount. The sector overall trades at around 8% less than tangible book value and fully two-thirds of European bank stocks trade below tangible book value, making it more expensive for them to raise capital.

But it's not just their weak profitability that scares investors away. The rules keep changing too. During the pandemic, authorities unilaterally shut down banks' dividend and share-buyback programs. And 15 years after the last financial crisis, regulatory capital rules have still not been entirely firmed up.

It's a point Jamie Dimon, chief executive officer of JPMorgan Chase, made in his annual shareholder letter recently. "It is in the interest of the financial system that banks not become 'un-investable' because of uncertainty around regulations that affect capital, profitability and long-term investing," he wrote. "Erratic stress test capital requirements and constant uncertainty around future regulations damage the banking system without making it safer."

Private capital injections were noticeably absent from the cleanup of bank failures last month. Given it was an aborted capital raise by Silicon Valley Bank that sparked its downfall, perhaps that's no surprise. But it certainly contrasts with the last big round. In 2008, JPMorgan raised $10 billion from investors to fund its acquisition of Washington Mutual from federal regulators, and Wells Fargo & Co. did the same to buy Wachovia.

This time, UBS, First Citizens and New York Community Bancorp each bought a failed bank without raising any fresh capital. Rather than deploy new equity to support acquired assets, they were each gifted equity from elsewhere. In the case of UBS, it came from Credit Suisse AT1 bondholders; in the case of the two U.S. banks, it came from the Federal Deposit Insurance Corporation.

"Transaction is self-capitalizing due to asset-discount structure," exclaimed New York Community Bancorp on its acquisition of Signature Bank, referring to the $2.7 billion of equity the FDIC threw its way.

And even though it was one of 18 bidders for Silicon Valley Bank assets, First Citizens was still able to negotiate a $16.5 billion equity injection from the FDIC — just enough for it not to have to raise outside capital. "We targeted that discount to support us being . . . within or above the target ranges for all of our capital ratios," said chief financial officer Craig Nix on the call announcing the deal. "So that's really sort of the anchor to which we attached the amount of discount."

It seems that no one wanted to raise capital.

As policymakers regroup to plot new regulations for the industry, they would be wise to take note. Squeeze the sector too much and private capital could continue to flee. The best form of contingent capital is private money waiting on the sidelines; alienate it and authorities will be left having to pick up the slack the next time a crisis comes around.