Banks Soon May Ramp Up Risk: Street Whispers

NEW YORK (TheStreet) -- Banks may soon begin to increase risk-taking to address shareholder concerns over profitability, despite efforts by regulators to limit such behavior.

Return on equity (ROE) has become a key focus for shareholders, a report last week from fixed income research firm Creditsights pointed out. Despite performing well by several metrics, recently ousted Citigroup CEO Vikram Pandit delivered poor ROE numbers relative to other banks. Citigroup's third quarter ROE was the second-worst among the 21 large-cap banks followed by Creditsights, narrowly edging out Bank of America (BAC)

"While the timing was definitely a surprise, the underlying message was pretty clear: The time for major balance sheet repairs and crisis cleanup seems to be over, and bank managers are getting renewed focus on delivering better shareholder returns," Creditsights wrote of Pandit's ouster. Creditsights notes that among the 21 banks it covers, the median ROE is 9.7%.

"In our view, ROEs need to earn at least the spread over the cost of capital, and acceptable ROEs are generally seen to be in the mid- to high-teens (12% to 18%). Since the onset of the crisis this range has been lowered to a 10-12% minimum given the industry's business model pressures," Creditsights analysts write.

Since regulators won't allow banks to increase leverage to boost returns, Creditsights expects them to enter new businesses or take on increase interest rate and credit risk. Such actions, the report states, would "add to bondholder risks."

Creditsights' interpretation of the rationale for Pandit's ouster contrasts with other possible explanations, such as Citigroup's rejection by regulators in its bid to return capital to shareholders, its losing a dispute with Morgan Stanley (MS) over the valuation of the Morgan Stanley Smith Barney wealth management unit. The Financial Times even argued that the selection of Michael Corbat as Citigroup's new CEO sent exactly the opposite message as the one being interpreted by Creditsights. According to the FT, "Citi's new boss epitomises the new breed of straightforward commercial bankers that is replacing their 'masters of the universe' peers from the investment banking realm."

But just because banks can no longer emulate Goldman Sachs (GS)--or Pandit's longtime employer, Morgan Stanley, by boosting leverage and making big trading bets, that doesn't they can't find other ways to take risks. Given how cautious banks and borrowers have become, it's only a question of when, not if, they will start to loosen up.

-- Written by Dan Freed in New York.

Follow @dan_freed

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.