The Outlook for Banks: Part 2

This is the second part of a two-part transcript in which Fool.co.uk's David Kuo chats with banking expert Ralph Silva from Silva Research Networks to discuss the outlook for the global bank sector.

They discuss the outlook for Barclays following the LIBOR debacle and the future of Lloyds Banking after the enforced sale of 600 branches to the Co-operative Bank. They also discuss whether HSBC can recover from its money-laundering scandal in Mexico. In this segment, Ralph also highlights three banks that he thinks could emerge stronger from the financial crisis.

You can read the first part of the transcript here. You can listen to or download the full podcast here.

EDITOR'S NOTE: What follows is a lightly edited transcript of David Kuo's conversation with Ralph Silva.

David Kuo: OK, so there'll be listeners to this podcast, particularly listeners who have investments in Lloyds Banking Group and Royal Bank of Scotland (LSE: RBS.L  ) (NYSE: RBS  ) -- and in fact, if we go the whole hog, we can say that we're all shareholders in both of these banks, because we are ultimately taxpayers. So how long will it take for a taxpayer to recoup the investments in these two banks, Lloyds Banking Group and RBS?

Ralph Silva: I think we have to separate the two, so let's talk about RBS first. My estimation is 12 to 18 months after the economy recovers, we'll see a return on RBS, and we'll see a return on RBS simply because, not their retail banking operations, but because of their other things -- their corporate operations, their investment banking operations. Remember that on a recovery, on an economic recovery, the biggest gainers are going to be investment banking and corporate banking, not retail banking. Lloyds, on the other hand, is a different kettle of fish altogether. I think we're looking at at least two or three years after the economy begins to recover. Now, if you're going to ask me when the economy recovers, it's anyone's guess. If you ask five economists, you'll get 10 answers.

David: OK. Now, can we move over to Europe? I've just come back from Fox Business News, talking about the eurozone crisis, and one thing that I was reminded of was that in Europe, we conducted this stress test of the European banks, and we found that only a few of them failed this stress test, but now we find that the European banks are not really as stress-free as we originally thought. They're going to need huge amounts of bail outs, particularly the Spanish banks. What has gone wrong with this stress testing of European banks?

Ralph: Well, to be honest with you, the stress testings were very new. The number of questions, the types of questions, are still evolving, and every time we do a stress test, they become more stressful, as it were. But far more important to that is that everyone seems to keep making an assumption that the economy's going to recover, and that's the problem. We have to put stress tests in place that are going to assume a 10-year recession, instead of a 10-week recession, because every time we assume that the economy's going to turn around in three months, we keep getting it wrong. I would prefer that we estimate on the opposite side -- let's assume a 10-year recession. I'm not saying we're going to have a 10-year recession, but if we assume that, we'll get a better picture of what's going on in the banking industry, which is exactly the reason why we're seeing these problems. Now, what's happened over the past six years or so is, for the first time in history, we have seen the financial services industry directly linked to the economy. They have been unable to move at a different speed than the economy, and simply because the margins are so low, that kind of makes sense in this particular environment. So we will not see a recovery in the financial services industry until we see a recovery in the economy, period, end, stop -- there's no other way to do it right now in the current situation.

David: But which comes first, Ralph? The chicken or the egg? Do you need to recapitalize the banks first, or do you need to wait for the economy to recover first? Because some people might say that banks are undercapitalized right now.

Ralph: I would agree. I think they are undercapitalized, but I think you have to look at it in a completely different perspective. The answer to this is politics; the answer to this is, we have to give, to give everybody in Europe a happy pill, and what I mean by that is, until people feel like they're going to keep their jobs, they're not going to buy new cookers, new cars or put extensions on their home. To be honest with you, I'm actually fairly impressed of the responsibility that's been shown by the public in Europe. They're not taking those risks. They're not making discretionary spends. I don't care how much money you put in banks, I don't care how much money they put out into small to medium-sized businesses, if people aren't confident enough to buy a new cooker, it's never going to happen, and that is a political situation, not necessarily a banking situation. So really right now, the banks are subject to politics, and the politicians aren't doing the right things to get people happy. We need to give everyone a happy pill.

David: But you're not going to get a recovery in Europe, are you, Ralph? Because until such time that the people have the confidence, I mean the European economies are very developed; in other words, somewhere close on to between 50% and 70% of their economies rely on retail spending, and if that's not going to happen, you're not going to get a recovery, are you?

Ralph: Well, we will get a recovery if -- and this is important -- if the people who have their jobs believe they're going to keep them, and we shouldn't expect people who are unemployed now to spend money on new cookers -- let's be clear about that. What I want to see is that, even in Spain, even in Greece, for that matter, there are lots of people who have jobs who are making money, who are actually living life a lot cheaper than they did before. Those people have to believe they're going to keep their jobs, so in essence, what we have to hear from Europe is, it may take a long time to recover, but right now we're not getting worse. That's the key thing -- we're not getting worse. People who have their jobs will start spending if they believe it's not going to get worse, and right now no-one believes that, and also we are always thinking that we have to have the economy recovering in the next three months. We don't -- we have to stop it from going down. That's all we have to do, and right now the politicians have not been focused on that.

David: OK, so what is your outlook for the European banks, then, given that you've painted this picture for the eurozone economies? What is the outlook for these European banks in Europe?

Ralph: I've put them into two baskets. The first basket is the large, very well-diversified European banks, BNP Paribus, Soc Gen, HSBC -- these types of organizations. I think that those particular organizations are going to do relatively well. Why? Because they're getting the lion's share of the investment banking operations, and also the corporate banking. What we're seeing is that, when a company needs money or a company wants to do an underwriting of whatever kind, they're actually gravitating to 10 banks, whereas 10 years ago they were gravitating to 200. So those banks that are getting the lion's share I think are going to do relatively well. Now, that leaves the middle area, so we have about 7,000 mid-sized banks in Europe. I am not positive about those organizations. I think we're going to have to see additional funding going into them, and as a result I think the governments are going to get fed up, and start forcing these organizations to merge. We're going to see great consolidation within the financial services industry over the next three to five years. I think most of it's going to happen because it's going to be forced to happen, not because it makes economic sense or no sense -- it's just because it has to happen, because we have to reduce the number of banks. But to be honest with you, in Europe right now we could lose 30% of the banks, and no one would notice. We'd notice because we have about 30% over-capacity in the banking industry in Europe already.

David: But are you saying that's not applicable to the U.K., because the U.K., they want more competition? I mean, this is what George Osborne and the coalition government is actually saying -- we need more competition in the U.K., and yet over in Europe you're saying we need more consolidation?

Ralph: No, I'm including U.K. when I say Europe, by the way, and I know that yes, the U.K. government wants more competition -- not just the U.K. government, every European government wants more competition, no question whatsoever. But it's not going to happen, and it's not going to happen because access to liquidity requires size, and we have to look at places. France is a good example -- Canada, Australia -- diversified organizations is the only safety against the next problem, and that's why we're going to see a proliferation of large banks instead of the small ones. I know the government wants it opposite, and to be honest with you, I think we should have more competition, I believe that, but it's just, the economics don't work.

David: But the thing about this providing of the liquidity, hasn't the ECB and also the Bank of England already provided billions, if not trillions, of liquidity to banks? Where has all this money gone?

Ralph: You know, I have to tell you, that is a great question, because I really don't know! It hasn't gone into my bank account, I'll tell you that much. I know that it's really to cover capital adequacy, and I think most of it's sort of sitting in liquidity pools somewhere to match capital adequacy requirements, and I think that's where most of it's sitting, and I think that a lot of it's going because banks have lost a lot in prop trading, so they need to keep alive and pay the bills. I don't think any of it's gone to customer money. I don' think any customers have lost money. I don't think governments actually support any of that, and I think that's the way it should be. But yes, there needs to be a better accounting of where each one of those pounds and those euros went to, because right now it's very, very weird.

David: It is very strange, and one of the things that is worrying people is that this money is just sitting in these European bank accounts at the moment, on their balance sheets, and what is going to happen when all of this money, a trillion in Europe and close onto 400 billion here in the U.K., does emerge from these banks, when the economic conditions start to improve, and you get one-and-a-half trillion just flooding the market, what is going to happen at that stage?

Ralph: Yes, but let's realize that, where's that one-and-a-half trillion? The vast majority of that is in the large, multinational organizations, so that's who got the majority of the money, which is my contention as well, that they're the ones that are going to get the lion's share of investment banking for the exact reasons you just described there. They have the money sitting in the accounts. They're going to win this game, because they have that money, but also, the liquidity that's been put in by the governments right now, that's not sustainable. So if you're going to be an investor, and you're going to invest for the short term, yeah, you can take that into consideration. If you're a medium to long-term investor, you'd better take that out of your calculations, because they're going to ask for some of that money back, so that's not a sustainable model right now.

David: OK, so if I ask you to pick three banks anywhere in the world, given that you are a global banking specialist, any three banks in the world that people could feel safe investing in, which would those three banks be?

Ralph: OK, if you're a medium to long-term investor, and that's really sort of the horizon that I look at, the three banks that I would pick are HSBC, BNP Paribas (NASDAQOTH: BNPQY.PK), and JPMorgan Chase & Co (NYSE: JMP  ) , and the reason for that is very simple: investment banking capacity. The vast majority of the banks are going to recover on the bank of corporate investment banking, and these are the organizations that are best positioned for that.

David: And these would actually sort of give you some kind of global exposure, these three banks that you referred to?

Ralph: And that's the other reason, is that they are global organizations that are well-diversified, so even if we see a problem in one or two parts of the world, it's not going to affect these guys very largely, but also the fact that these guys already have a substantial number of customers who are weighting to invest, so they're holding the monies from the Fortune 1000 companies already. When they want to build new plants, these are the guys that are going to give them the extra money, and that's why they're going to be first. Now, let's just be clear -- short-term investments, I don't suggest this story. 

David: And why is that?

Ralph: Because right now, what I would call the delta of these organizations is what's the best. They are being kept down, because the industry is being kept down. Their incremental increase is going to be greater than anywhere else. For short-term investing, I've got to tell you -- the three or four biggest banks in Brazil is where I put my money.

David: OK, well that's absolutely wonderful, and in terms of how you see the global economy, if I were to speak to you in a year's time, what would you say the economy would look like?

Ralph: I am going to be very happy if, in a year's time, we say that things did not get worse. I think we're looking at an 18 to 24 month horizon before we actually see any measurable improvement in the economy on a global basis, and I'm including Asia, I'm including South America, and also the U.S. I think it's going to take some time before we turn this all around.

David: OK, and out of those three banks that you mention, I didn't see a Chinese bank in there, apart from HSBC, which was founded in China many, many centuries ago. I didn't see a Chinese bank -- why is that?

Ralph: They're already overvalued, in my opinion. I think that we've put so much emphasis on China and the Chinese market that the valuations of these banks are relatively high. I think they're going to do very well; don't get me wrong, I think they're going to do very well, but I think you're going to get a better improvement on the three that I mentioned than you are on the Chinese banks.

David: OK, well that's wonderful. I think that's a great place to stop, on a high note, Ralph. Thank you very much for joining me today. Before I let you go back and recuperate, I have just one more chore to perform, which is to find a quote to sum up today's podcast, and the quote comes from a Greek philosopher called Epictetus, who said: "Ruin and recovery are both from within," and I think that probably sort of refers to the three banks that you're talking about; ruin and recovery will come from within the banks themselves.

Ralph: Very appropriate -- absolutely. These banks have made their problems themselves, and they're the only ones that can fix them -- they just have to focus on getting everything done, and that means focusing on the customer and giving them what they want and they need.

David: OK, that's wonderful. This has been Money Talk, I have been David Kuo, and my guest has been Ralph Silva from SRN. If you have a comment about today's show, please post it on the Money Talk web page, which you can find at fool.co.uk/podcast, and until next week, happy investing!

That was the second part of a two-part transcript in which Fool.co.uk's David Kuo chats with banking expert Ralph Silva from SRN to discuss the outlook for the global bank sector and three banks that could emerge stronger from the financial crisis.

In the first part of the transcript, David and Ralph discussed the outlook for Barclays following the LIBOR debacle and the future of Lloyds Banking after the enforced sale of 600 branches to the Co-operative Bank. Just click here to continue reading.

David Kuo challenged his Motley Fool analysts to pinpoint the attractive sectors of 2012 -- and they delivered! Discover the industries they selected in this new Motley Fool guide -- "Top Sectors for 2012" -- while it's still free!

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David owns shares in Barclays. The Motley Fool owns shares of JPMorgan Chase. Motley Fool newsletter services formerly recommended JPMorgan Chase. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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