This article originally appeared on Forbes.com.
Many U.S. banks are enjoying a period of strong profits and surging equity prices. But we see troubling signs of overoptimism: Less resilient, financially vulnerable banks have attracted relatively high valuations. Investors have not distinguished much between the weaker and healthier banks, an eerie similarity to banking valuations in 2007, just prior to the global financial crisis.
Bain & Company’s recent health check of about 600 banks in the U.S. derives a score from two dimensions. The first is asset and liability health, especially the quality of assets. The second is profitability and efficiency. This provides a more integrated view than looking only at a balance sheet or income statement. We calculated a score for each bank and placed it in one of four categories for year-end 2016, the latest period for which data is available: highest concern, weaker balance sheet, weaker business model and winners.
Roughly 23% of the banks fall into the highest concern category, including five of the 25 largest banks. Alarms should sound, because nearly every bank that failed in the past decade, as well as many that merged into other entities, fell into this category prior to a failure or merger.
About 30% of the banks we analyzed attain the “winners” position, with both robust financial and balance sheet health. As for the rest, 28% have weaker balance sheets, and 18% have weaker business models, producing less attractive financial performance.
When we compare the largest 100 banks in the U.S. and in Europe, there is a longer tail in Europe toward the highest concern category. In other words, relatively more European banks are at risk of failure than US banks. That may be because US banks have a stronger position on profitability and efficiency—a greater ability to turn a profit with assets on hand.
In the US, however, investors have a skewed perception of bank stocks. The average price-to-book ratio is 1.46 for the least resilient category of banks, not much less than the 1.7 for the U.S. “winner” banks. U.S. investors today (unlike in 2009, after the crisis had bitten hard) make very little distinction for balance sheet stability, and are overvaluing the riskiest banks.
Their bets could come a cropper in the near future. It has been nine years since the last major market downturn, and while no one can predict the exact nature and timing of the turn, one will come that could be more severe than the recent bout of market volatility. Should a downturn occur while valuations remain stretched for weaker institutions, there could be a domino effect in which the failure of one or more banks, even smaller entities, drags down others.
Weaker banks probably have a limited window of opportunity. The roughly 140 banks analyzed with poor profitability and weaker balance sheets should improve their asset quality, liquidity or capital adequacy as soon as possible.
How can they do that? They can learn from some of the banks in Europe that were able to pull themselves out of a downward spiral. One European bank, for instance, restructured troubled loans by disposing of repossessed factories over three years. It discarded legacy businesses and created new ones built around customers’ needs and priorities, rather than simply pushing products. The bank sharply reduced its cost base by around 30% to reinvest in new activities, and reduced its dependency on wholesale funding by increasing the level of deposits. Persisting through a series of difficult decisions, this bank managed to move from near death back to robust health.
Despite the capital-adequacy rules and stress tests devised in recent years, many U.S. banks still have relatively weak positions. Yet investors do not appear to factor these weaknesses into their valuations. Several reasons could account for their betting on a bull rather than a bear, including a belief in continued consolidation with acquirers paying a premium, forecasts of rising interest rates, or the hope that most banks will not succumb to the domino effect. Among bankers themselves, many believe the sector is healthier than before the crisis, so they view the valuations as rational and a confirmation of their strategies.
The data suggests to us that investors remain in a zone disconnected from the realities of banks’ financial health, similar to their stance before the crisis. And regardless of the average state of health for U.S. banking, the least resilient banks cannot afford to ignore the data that signals how vulnerable they really are.
Joe Fielding and João Soares are partners with Bain & Company’s Financial Services practice, and Mike Baxter leads the practice in the Americas. They are based, respectively, in New York, London and New York.