As readers of my posts know, I am not a big fan of investing in the banking sector at this time. Let's look at the five large financial institutions reporting this week.
Wells Fargo (NYSE:WFC) has outperformed everyone else with a return on equity of 11.96 percent. Of the five, Wells Fargo is the only one that is listed as a commercial bank. The commercial banking sector is earning 6.95 percent on shareholder equity.
Three others, JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC), and Citigroup (NYSE:C), are listed as diversified financial services organizations. This segment of the financial market is earning a return on equity of 13.35 percent. However, JPMorgan is earning 8.40 percent on equity, Bank of America is earning 4.61 percent, and Citigroup is returning 6.32 percent.
Goldman, Sachs (NYSE:GS) is included in the capital markets sector of the financial market and is earning 11.96 percent on equity. The capital markets sector, as a whole, is earning 13.61 percent on shareholder equity.
Wells Fargo and Goldman Sachs have not had a return on shareholders' equity of 15.00 percent or more (my magic number) since 2007. Bank of America and Citigroup have not reached such levels since 2006.
Bank of America acquired Merrill Lynch and Countrywide Financial in 2008 causing assets to rise and ROE to fall.
And, one has to go back to 2003 before JPMorgan reached or exceeded the 15.00 percent benchmark. The year 2003 was the year before JPMorgan, Chase acquired Capitol One, where Dimon was President and CEO. Consequently, in 2004 JPMorgan's assets shot up and its ROE fell dramatically. In 2008, it acquired Bear Stearns and Washington Mutual. In that year, assets also shot up and ROE dropped significantly.
In the 2000s, none of these banks really earned more than their cost of capital in the fundamental business of "banking". That is, in the area where banks take in deposits and make loans, these organizations basically earned their opportunity costs.
Wells Fargo made its way in the "commercial banking" end of the business by become a mortgage bank earning fees by originating and then selling and servicing residential mortgage loans. It was able to keep costs relatively low and now are profiting as loan charge offs are dropping and it can reverse money out of loss reserves it had previously set up.
But note, as mentioned above, banks classified in the commercial banking sector only earned, only earned slightly less than 7.00 percent of equity in 2013. And, if one looks out over the past ten years or so, the average return in this sector was barely up to the cost of capital for the industry.
The exceptional earnings performance in the other four companies before the financial crisis came from "investment banking" side of the business with financial innovations playing a significant role in the profit making. Here fees and trading played a very important role in how the companies did. In fact, it was the investment banking side of the business that compensated the banks for keeping up with the "traditional" banking model.
This can be seen by the average return on shareholder's equity in the diversified financial services industry and in the capital markets industry. It is no wonder that commercial banks like JPMorgan, Chase, and Citigroup and Bank of America wanted to expand into areas like the ones that Goldman, Sachs inhabited.
Where are these companies now seeing some progress? Well, for one, cost cutting has become a major component of most of these organizations. During the "good times" these banks added more and more personnel and overhead to "go with the wave" that everyone was experiencing. Now, the cutbacks have become very serious.
In addition, managements are withdrawing funds from loan loss reserves as the performance of loan portfolios improves.
During earlier months of the recovery, fixed-income trading contributed to profitability, as did the number of mortgage refinancings rose. Recently, fees for equity issues have been up as new initial public offerings increase. Furthermore, it looks as if the business connected with mergers and acquisitions will be increasing.
But, note … these improvements are all associated with the investment banking side of the business. And, the contribution that each of these different sources makes each quarter can vary substantially as the economic and financial environments change.
Results like these, I believe, will be the norm for the next year or so.
In terms of the traditional banking" business, net interest margins will rise as interest rates rise and this will help. But, I still cannot see the return on equity in this side of the business improving beyond banks' cost of capital.
Traditional banking is nothing more than a "commodity" business in the twenty-first century. So, in my mind, banks are going to have to become more and more and more efficient in controlling their cost basis. Banks are going to have to reduce the number of branches they have and they will have to reduce the number of employees on their books. They are going to have to reduce back office expenses. And, they are going to have to be more and more electronically savvy. Money, loans, transactions are just information and information technology scales.
This is also true on the investment banking side of the ledger. The bigger banks are already pretty sophisticated in this part of the business. But, in becoming even more sophisticated these organizations are going to have to become more innovative and aggressive. In addition, these organizations are becoming challenged more and more by firms that are not in their industry…firms that are in the "shadows."
Two things we are seeing here. First, the regulators are trying to "open up" this part of the industry by encouraging trading that is not "over-the-counter" and, hence, more transparent. They are also working in other "transactions" in this investment banking sphere. Second, regulators have shown great concern over the pace of financial innovation. Of course, the banks are fighting these efforts. One reason they are fighting is that there are un-regulated competitors that do not have to conform to these rules … yet.
Overall, I believe that the single most important factor that is driving the future of banking is technology. Yes, the economy is improving. Yes, banks are becoming healthier. But, information technology is spreading throughout the culture and is becoming more and more ubiquitous. This will make banking … both traditional banking and investment banking … more like a commodity. So, in the short-run, these "banks" might regain some of their glitter … but in the longer run, I don't see these "banks" earning more than 10 percent to 12 percent on equity. Competition is going to come from everywhere.