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Post Election, Banks May Get Real

Banking shares are down sharply since the election, but the threat of tough regulation now moving markets might hold a kernel of hope for investors.

There are reasons to think that a smaller, less grandiose future will be very good for bank investors, if it comes.

Bank shares are not just cheap because of cyclical difficulties; they are cheap because investors, stung by intermittent scandals and extreme volatility in earnings, have imposed a sizable discount. Smaller banks and less risky banks may earn less on a return-on-equity basis, but could be able to obtain a better valuation on those lower, but safer, earnings.

In an industry in which employees take home up to half of revenues, the multi-decade boom in financial intermediation has tended to leave shareholders out in the cold, as banks compete for talent in what was for most a vain attempt to be a universal bank. As that reverses, look for compensation to drop, which will flatter the bottom line.

There is nothing the market likes better than certainty and trimmer banks in fewer lines of business, and with viable franchises, will produce more predictable profits. Higher profitability, helped by lower compensation, combined with less volatility should make investors willing to pay more for bank shares.

TURKEYS APPLAUD THANKSGIVING?

There are, obviously, huge risks to betting on this outcome. The first is that hoping bank executives become cautious stewards of shareholder money is akin to expecting turkeys to vote for Thanksgiving. It is not in their best interests and it involves accepting that rapidly expanding their firms was foolish or worse. No one likes paying themselves and their friends less and, at the same time, admitting they were either fools or knaves.

An investor's only protection here is leadership and knowing the board and top executives, how they think and where their bread is buttered is key. Do not expect JP Morgan under Jamie Dimon or Morgan Stanley under James Gorman to pull a UBS.

The second big risk is that, although we might believe that highly capitalized banks with safer profits are good investments, bank share prices might still have far to fall to get there.

The time to buy banks may not quite have come, but we are getting closer and it bears watching.

Copyright 2012 by Reuters. All rights reserved.

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