Quarter 3 Bank Earnings Start Tomorrow…

Nice read in the Banking sector in the Wall Street Journal this morning:

Seven years since the global financial crisis, banks don’t look like a source of trouble. They’re making money and have thickened their buffers against bad loans, while extensive new rules have excised much of the risk from their operations.

Yet the sudden resignation of Wells Fargo & Co.’s chief, John Stumpf , and the turmoil engulfing Deutsche Bank, tell a darker story. In different ways, they show how much harder it has become for banks to make money. The stock market suggests banks aren’t expected to earn much more than what investors charge them for capital in the foreseeable future. Blame rock-bottom or negative interest rates, tougher regulation and weak economic growth.

An industry that can’t earn more than its cost of capital is an industry destined to shrink. This matters to more than just the banks and their shareholders. When central banks ease the supply of credit, they rely on banks to transmit the benefits to the broader economy by making loans, handling trades and moving money between people, companies and countries. Shrinking, unprofitable banks hobble that transmission channel.

No politician wins votes by feeling sorry for banks. Quite the opposite: Democratic presidential nominee Hillary Clinton would make it easier to punish miscreant bankers while charging banks a new “risk” fee.

Some finance officials, however, are starting to worry.

“We don’t have a banking crisis, we have a profitability crisis,” Hans Jörg Schelling, Austria’s finance minister, said recently. Central banks in Europe and Japan are skittish about cutting interest rates even further for fear of undermining their banks.

The point is illustrated well by a recent study by Natasha Sarin and former Treasury Secretary Larry Summers, both of Harvard University, and presented at the Brookings Institution. They decided to assess the stability of banks not as regulators do, which usually means looking at capital (such as shareholders’ equity), but as markets do. They examined the behavior of common shares, preferred shares, options, credit default swaps and various valuation yardsticks.

They discovered that markets think banks are much more likely now to lose half their market value than before the crisis. They interpret this as a “decline in the franchise value of major financial institutions, caused at least in part by new regulations.” The counterintuitive implication: The bevy of rules designed to make banking safer may, by endangering their long-term viability, ultimately achieve the opposite.

One telling data point is the decline in the ratio of banks’ market value to the value their books say they are worth. For example, Bank of America Corp. and Citigroup Inc., which traded at about double their book value before the crisis, have since traded below, as have banks in France, Germany, Japan and Italy.


That means investors think that banks will be earning negative returns on their assets, after costs. And indeed, the Institute of International Finance, which represents global banks, finds that since 2010, European, Japanese and U.S. banks have on average been earning less than their cost of capital.

Regulation is part of the reason. To better buffer loan losses, banks must now hold more capital such as shareholders’ equity, which spreads​profits across more shares. To deal with sudden outflows of funds, they must hold more highly liquid short-term assets, such as Treasury bills, which earn less than loans.

This has been compounded by the sluggish economy, which has held back loan growth, and by monetary policy. Banks profit from the spread between the interest they charge on loans and pay to depositors. But loan rates have been pulled down as central banks hold short-term rates at or below zero and buy bonds, and banks are reluctant to pass that on to depositors by charging to hold their money. Moreover, when central banks buy bonds, they pay with newly created cash that sits on banks’ balance sheets earning nothing, or less.

This can explain a lot of the problems in Europe’s banks, including Deutsche Bank, which is facing a potential multibillion-dollar U.S. penalty over crisis-era mortgage activity. The German powerhouse has €123 billion ($135 billion) tied up in cash and central-bank deposits. Meanwhile, its investment banking revenue has been sapped by regulations and docile markets. George Karamanos, an analyst at Keefe, Bruyette and Woods, says if current interest rates persist, by 2020 European banks’ profits will drop 20% and Deutsche Bank will be unprofitable.

Wells Fargo seemed to separate itself from its peers by boosting the number of products such as accounts and credit cards each customer bought. But in the process, many customers ended up with accounts and cards they didn’t want. Not only did that business earn nothing for Wells, it cost it a $185 million penalty, some $20 billion in market value and Mr. Stumpf’s job, and triggered a Justice Department investigation.

Indeed, investors must now discount the possibility that any bank could be one scandal away from indictment and a crippling, multibillion-dollar fine. Banks have responded by exiting or downsizing businesses that carry the most reputational risk, such as international money transfers and issuing mortgages to less creditworthy borrowers.

Those who blame many of the economy’s ills on a wasteful and overgrown financial sector will no doubt cheer this retreat. Everyone else should worry.

JimmyBob (Scott)has been trading equities for over 15 years, a majority of which were OTC micro-cap stocks. He started trading high risk stock options over the past 7 years, and has proven winning trades in excess of 15,000%.

As one of the Co-Founders of optionmillionaires.com, Scott enjoys sharing his knowledge with other investors through timely blog posts, daily watch lists in the forum, weekly webinars, and helpful advice within the chatroom.

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