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Banking On An Economic Recovery

If anyone so much as dare to suggest that the problems in the global banking industry could have been caused by anything other than serious mismanagement, they are likely to be bombarded by a stream of hate-mail.

Did some banks mess up? Yes they did. Did some try of dupe customers? Yes they did that too. Did some banks try to sneak money from one country to another under the noses of regulators? Yes, some have been guilty of that.

Did some banks try to rig interest rates for their own benefit? Yes, some have been caught with their fingers in the till. Did some banks try to package up toxic assets into seemingly innocuous products that were then sold to unsuspecting consumers? Some are guilty of that too.

Same again?

But here’s the question: Is this likely to happen again? The answer is probably yes.

However, their future misdemeanours are unlikely to be the same as previous wrongdoings. Nevertheless, there are likely to be more transgressions in the future. The problem with banks is the sheer complexity of their business.

To describe banks as a sausage machine is probably not too far off the mark.

Money goes in at one end, and we hope that money comes out in the form of profits and dividends at the other. But what exactly happens inside the banking machine is almost unfathomable to shareholders, analysts, auditors and regulators, as much as we would like to kid ourselves that they are.

Regulators might like to think that they can cover all the bases. But their task is no easier than trying to catch mosquitoes with a colander. No sooner is one loophole closed than another opens up, ready to be exploited by unscrupulous bank staff.

What is even more galling is that for many years any gap that opens up is likely to remain undetected until damage has already been done.

It’s a cycle

However, whilst much attention has been focussed on the past misbehaviours by banks, it is important to not lose sight that banks are cyclical businesses.

They are, by their very nature, at the forefront of the economy. They lend money when conditions are good, almost to the point that they might even force-feed credit to consumers and businesses. But through their actions, they propel economies forward. Without them, we would probably not even have an economy to speak of.

The current business cycle is unlikely to be any different to past cycles. When global economies were strong, banks such as DBS Group (SGX: D05) were making as much as S$12 profit on every S$100 of equity invested by shareholders. Meanwhile, Oversea-Chinese Banking Corporation (SGX: O39) and United Overseas Bank (SGX: U11) were making nearly S$17 profit on every S$100 of shareholder investment.

However, by the time the financial crisis of 2008 unfolded, those returns were almost cut in half. But banks have been through harsh times before, even if we might not remember them ourselves. Following the bursting of the dot-com bubble in 2000, bank profits fell, as did their returns on shareholder funds. But banks recovered.

Getting better

Banks are showing signs of improvement this time too. Profitability has recovered, as have their Return on Equities. Currently, Singapore’s three quoted banks are delivering around S$11 of profit for every S$100 of shareholder equity.

Could now be a good time to invest in banks? The answer is it depends. If you believe that talk of a gradual hardening of interest rates could be a sign of an improving global economy, then banks could be one way to capitalise on it.

As Hong Kong entrepreneur Gordon Wu once noted: “Whenever there is a financial crisis, it is always the banks that get hit.” The converse of that is that when the financial crisis is over, banks could recover their swagger.

The question for bank investors is whether they believe the financial crisis of 2008 is now over. Or could we be on the cusp of another financial crisis?

A version of this article first appeared in the Independent on Sunday.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.