Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Ever since the Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted  in 2010 to avert a repeat of the 2008 financial crisis, endless debates have taken place about whether the law and its accompanying regulations are too hard on financial firms.

No matter your opinion about Dodd-Frank, it’s hard to get around the fact that financials have struggled to keep up with their nonfinancial peers since the law was enacted. The return on assets for the S&P 500 Financials Index has averaged 1 percent since 2011, compared with an ROA of 2.9 percent for the S&P 500. The average ROA for the financials index is also the lowest among S&P 500 sectors. 

Back of the Pack
The financial sector is struggling to keep up
Source: Bloomberg
Note: Numbers as of July 23, 2017.

Similarly, the return on equity for the financials index has averaged 8.5 percent since 2011, compared with an ROE of 13.9 percent for the S&P 500. The average ROE for the financials index is the third lowest among S&P 500 sectors, edging out an energy sector in the throes of a historic collapse and a perpetually sleepy utilities sector.

But fans of Dodd-Frank say the numbers are finally on their side. As Bloomberg News reported last week, “Ten of the nation’s biggest lenders including JPMorgan Chase & Co. and Bank of America Corp. together made $30 billion last quarter, just a few hundred million short of the record in the second quarter of 2007.”

Making Lemonade
Financial firms have found ways to increase earnings despite years of flat revenue growth
Source: Bloomberg

Barney Frank, the former congressman and Dodd-Frank’s co-sponsor, declared that those second-quarter profits show that “the legislation we passed in no way retarded the ability of the banks to make money.”

The market, however, isn’t as impressed as Frank with the financial sector’s ability to make money. The price-to-earnings ratio of the financials index is 15.9, based on one-year trailing operating earnings, compared with a P/E ratio of 24 for the S&P 500. The P/E ratio of the financials index is also the lowest among S&P 500 sectors.

The market doesn’t think much of the sector’s assets, either. The price-to-book ratio of the financial index is 1.4, compared with a P/B ratio of 3.2 for the S&P 500. Here, too, the P/B ratio of the financials index is the lowest among S&P 500 sectors.

It’s not surprising that the market disagrees with Frank. For one thing, the financial sector’s struggles have more to do with revenue than profits. The profit margin of the financials index is a plump 15.1 percent, which is well above the S&P 500’s profit margin of 9.1 percent and second only to tech among S&P 500 sectors. Revenue, on the other hand, fell 8.3 percent the year after Dodd-Frank was enacted, and the sector struggled to increase revenue for years. Revenue finally rose in 2016, but it still hasn’t returned to its pre-crisis levels.   

Moving Sideways
The financial sector has struggled to increase revenue since Dodd-Frank was enacted in 2010
Source: Bloomberg

Also, the market doesn’t care how much financials make in absolute dollars. What’s important is how much they make relative to the investment necessary to generate those dollars. In other words, until financials generate higher returns on assets and equity, the market is likely to shrug.

On that, the market has been unwavering. The financials index hasn’t enjoyed a higher valuation than the broader market since Dodd-Frank, and it hasn’t even been close. The P/E ratio of the financials index has averaged 15.2 since 2011, compared with 19.9 for the S&P 500. And its P/B ratio has averaged 1.3, compared with 2.6 for the S&P 500.

Shrug
The market hasn't been impressed with financials in recent years
Source: Bloomberg
Note: P/E ratio based on one-year trailing operating earnings.

It’s possible, of course, that Dodd-Frank has little to do with the financial sector’s woes, but the market doesn’t seem to think so. Consider that the financials index traded at a P/E ratio of 13.7 just before the U.S. presidential election. A month later, with President Donald Trump promising to repeal Dodd-Frank, the P/E ratio jumped to 15.5.

That P/E ratio has declined in recent months to 15.9 from its high of 16.7 in February, as Trump’s agenda has looked increasingly precarious. Still, financials are 16 percent more valuable today than before the election based on P/E, and 28 percent more valuable based on P/B.

I’m not suggesting that Dodd-Frank should be repealed or even rolled back, but let’s acknowledge that regulations have a cost. The market is often better informed than any individual observer, and what it’s saying is that regulations like Dodd-Frank that are meant to keep a lid on financial firms are doing their job.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in New York at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net