A slump in the lucrative structured-finance business and regulators' demands for bigger capital reserves mean that stratospheric profitability at banks is gone, possibly forever.

The credit crunch has been a sharp drag on the return on equity, a main gauge of bank profitability. It has particularly affected banks in Europe and the United States since the second half of 2007, and those returns may never recover to precrisis levels.

"Will the fantastic returns of 2006-early 2007 come back?" asked Bernd Ackermann, an analyst for Standard & Poor's. "It's really doubtful. It was a unique environment where each and every asset class appreciated, so it was very difficult to do anything wrong,"

In 2006, the top 10 banking returns on equity ranged from 23.9 percent to 35.5 percent, with the average return at 13.6 percent, according to the Boston Consulting Group.

Last year - split neatly into a record first half and a sharply slowing second half - banks' after-tax profits fell for the first time since 2003 and their average return on equity declined to 13 percent, but that was propped up by exceptional returns at some banks, mostly from emerging markets.

"Until last year, we'd had a 25-year run of low interest rates, excessive liquidity, particularly post-9/11, low inflation and relatively good economic growth," said Neil Dwane, chief investment officer in Europe for RCM, an investment unit of the German insurer Allianz.

Regulators will require banks to set aside more capital than before for risks other than that of default, like potential losses because of a credit rating agency downgrade or because of a change in the price of an equity instrument.

"Does that permanently diminish ROEs?" asked David Fanger, an investment banking analyst at Moody's, referring to return on equity. "It may very well."

Dwane said that the high returns enjoyed by banks in 2006-07 are gone for good.

"In two, three years these businesses will be regulated and as exciting as utilities," he said.

Large banks across the world, including Merrill Lynch, UBS and Citigroup, along with other financial firms, have written down $408 billion since the crisis hit, pressuring their return on equity, an important benchmark for shareholders.

The return on equity at UBS and Citigroup slipped into negative territory this year, compared to high positive returns last year. A JPMorgan Chase analyst, Kian Abouhossein, estimates that measure next year will still be considerably below the precrisis levels, or around 20 percent for UBS and around 11 percent for Citigroup.

According to Standard & Poor's, Goldman Sachs posted a return on equity of more than 30 percent in 2006. JPMorgan sees that figure at around 19 percent by the end of 2009.

Return on equity reveals how much profit a company generates with the money shareholders have invested. It is defined as after-tax profit divided by total equity - so the higher the percentage, the more profitable the company.

Standard & Poor's said it expects investment banking revenues to drop 20 percent to 30 percent this year on 2007, excluding write- downs.

"For 2009, I wouldn't say that this will improve dramatically," said Ackermann, the Standard & Poor's analyst.

Also pressuring income at banks is the loss of a rich steam of revenue from structured products, which became a major contributor to the subprime fiasco because their complex nature made it hard to assess risks and value.

Demand has evaporated for asset-backed securities and collateralized debt obligations after the market for such debt repackagings froze in the wake of the blow-up in the market for U.S. subprime mortgages.

While structured finance may pick up in the future, products are likely to be simplified, subject to intense scrutiny and, in all likelihood, less profitable, analysts say.

And it is already costing banks more to satisfy investors as they look for higher dividends to compensate for the risks of investing in financial institutions just as their share prices drop.

"Involuntary balance sheet expansion, higher funding costs and the need for stronger capital ratios are likely to result in a permanently lower return on equity for the industry," Citigroup analysts said in a note on British banks.

Originally published by Reuters.

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