The commercial banks have come to a fork in the road. The banks must choose one of three directions:
- The traditional deposit-taking and lending earnings squeeze.
- Dealing and dying.
- Something new.
As the chart, below, taken from the St. Louis database, FRED, reveals, the banking industry in its traditional form - deposit collection for the purpose of lending - is producing profits at the pace of the rush hour traffic jam it has become. The traditional banking business will consolidate until the remaining banks in the traditional banking business have the necessary sleek cost structure consistent with the new reality of narrow spreads revealed by the chart. And that means the survivors will inevitably be big. Wells Fargo (NYSE: WFC) is well in the lead in this race at the moment.
Banking margins have been collapsing for some time. It was not until 1970, however, that a way out of this squeeze presented itself. Just as banking margins began their long term fall, the Bretton Woods Agreement collapsed, and OPEC put the squeeze on the supply of oil, generating inflation and blowing up interest rates until wholesale dollars fled the country for their new home in London.
Historically, the large dealer banks were the first to cotton to this state of affairs - a confluence of the death of their old base corporate lending business with the rise of a new opportunity. They saw the freeway on-ramp escape from the slow lanes of traditional banking. The freeway sign read: Fixed income, commodities, and currencies trading (FICC).
And fundamental to the current disastrous circumstances in which the business now finds itself, is the mistake they made then. As the dealers left borrowing and lending for dealing, they blew up the bridge behind them, creating a trading monopoly. Perhaps they were afraid that otherwise, their trading hides would have been chewed up by the people, investment banks, who already knew the trading business.
The rules of FICC were elegant in their simplicity. In a world of ever-shrinking net interest margins, buy and hold is a fool's game. The FICC credo was buy, but buy to sell or bury. Never buy to hold. Ironically, it was the government that laid out this FICC blueprint, by privatizing Fannie Mae and Freddie Mac, which, with investment banking help, came up with the original securitization, the mortgage-backed security. But the reality is that FICC, the large banks' bread and butter for almost half a century, is about to become yesterday's news.
A number of analysts, such as Alhambra Investment Partners, and John M. Mason, see something persistent, and negative, about the most recent earnings results of the major dealer banks, such as Bank of America, (NYSE: BAC), Citigroup, (NYSE: C), Goldman Sachs, (NYSE: GS), and JP Morgan Chase (NYSE: JPM).
In this earlier article, I discuss the dealer banks' recent quarterly releases, which I found to be bleak. With the exception of GS, there was an absence of plans consistent with reality. As pointed out by the analysts named above and others, there were poor results in fixed income across the board. There were two consensus explanations:
- This was a "tough quarter."
- Regulators are hindering the otherwise insanely profitable trading activities of banks.
Without denying that either of these explanations has some veracity, I think bank valuation based on either of these two arguments will not capture the future performance of individual banks and other financial institutions.
The banks appear to behaving in a manner consistent with explanation 2. There are layoffs of high-priced traders across the board. The Alhambra article cited above suggests that the entire OTC trading business is dying. This is a broader, and slightly different, position on the future of dealing than the one I have taken in earlier articles, for example, here.
My past position here on Seeking Alpha has been that derivatives dealing, as currently structured, is problematic, and that the dealer banks have not responded to the glaring inefficiencies in OTC market practices in a way that credibly takes them to a profitable place.
Instead of seeking market efficiencies by creating instruments that function in trading venues with market prices and non-bank participants, the banks have holed up in their own domains - the interbank markets and the OTC clearers - where the values of portfolios are found through banks asking themselves what they think they're worth and how much risk they think they're taking.
That is worth repeating. The dealers determine their own market valuations and provide their own descriptions of risk.
Of course that process is eventually contained by the fact that the dealer banks have to pay the bills - mainly bonuses and including considerable legal settlements resulting from OTCs dubious practices - and provide dividends. But a stockholder who depends on dividend receipts for proof of performance is a trusting sort.
I have questioned the future of OTC interest rate swaps dealing, and the continued value of the stock prices of those banks whose employee compensation is based upon the continued profitability of fixed income, currency and commodity trading (FICC) margins as they existed before the Crisis.
But in fact, I agree in part with Alhambra's position: The whole OTC trading business is broken. However, the derivatives business is only the part of the OTC trading business with a short run fix. Derivatives can be fixed by simply listing the right instrument on an exchange. The problems of derivatives markets, in particular, will be solved, because bank customer demand for these derivatives is undiminished. But the whole edifice of OTC inter-bank trading is under assault.
Dodd Frank - with its promise of eliminating "too big to fail," questionable mortgage lending, shadow banking, and systemic risks of derivatives trading - has begun to close the door on the dealer banks' old OTC monopolies. But this was done without confronting the fundamental issue.
The fundamental issue is the walls banks have built around the business of dealing in OTC risks, through the bank monopoly in inter-bank trading of currencies, dollar wholesale deposit markets (Eurodollars) and derivatives instruments. This monopoly is gradually being eroded by the pressures of competition from some of the newer market participants, such as trading-oriented hedge funds like Citadel, on one hand; and through pressure to reduce the extreme size of the activities of the bank dealers from regulators, on the other.
"OTC monopoly? What OTC monopoly?"
But there are no banks that are going to produce consistent profits, going forward, if they are burdened with the dealers' cost structure, primarily their employee compensation and recurring legal fees. These markets, like those for securities trading, are headed in the direction of electronic trading. And you cannot command a $1 million bonus if your sole responsibility is to show up at eight in the morning to turn on the dealing computer.
The derivatives markets have taken the first step down the path to efficiency, as bank dealers have been dragged, kicking and screaming, to the use of derivatives OTC clearing counterparties.
But the dealers have foolishly halted the flow of progress toward market efficiency, temporarily, by co-opting the OTC Clearing Houses. In part this is the fault of the United States clearing management firms, ICE (NYSE: ICE) and CME Group (NASDAQ: CME), who are at least nominally independent of the dealer banks, yet never considered a means of opening trading of these instruments to non-banks. LCH:Clearnet, a subsidiary of LSE Group in London, has always been dominated by the dealer banks, and so it comes as no surprise that the instruments traded there, OTC interest rate swaps, are designed so that only the major dealer banks have a say in the design of trading technology.
It astonishes me how successful LCH:Clearnet has been in persuading the world that the $280 trillion in cleared interest rates swaps found in London are nothing to be concerned about.
But perhaps the most interesting accomplishment of LCH:Clearnet is the persuasion of the public that the settlement of Lehman Brothers OTC cleared derivatives portfolio upon Lehman's collapse was a success.
It actually was a lobbying coup. Thanks to Congress' change in the bankruptcy law, the Exchange was able to value, seize, and convert Lehman's collateral before other creditors could touch Lehman's assets at all. The exchange decided what Lehman owed, decided the value of Lehman's collateral, and seized it before any court contemplated the value of other claimants' share of Lehman's assets or who should receive what.
However, the dealers' days of controlling the OTC markets are numbered. On one hand, technology is going to open the OTC markets to non-bank traders. The way is clear enough. The market needs negotiable instruments. One example of an existing traded vehicle upon which OTC market competitors could be built is the currency ETF. These are still inefficient at the wholesale level compared to other possibilities that I describe here. But the ETFs will soon generate enough liquidity to present the opportunity for enterprising non-banks to "manufacture" alternatives to the Eurodollar deposit and the foreign currency forward for valuation purposes. Other changes in trading technology are also afoot.
The second reason that the old ways of OTC dealers are doomed is that regulators are moving on the excessive market concentration of the bank dealers. As the dealers face ever higher capital charges due to the consolidation of the dealing business in such few hands, the pressure to leave the dealing business grows ever stronger.
So where can the big banks turn? Several seem, on the evidence of their end-of-quarter plans, to be thinking they can return to the strategy they once deserted - the basic banking business of borrowing and lending. There are two things wrong with that belief.
- Counter to popular belief, this is a tough business that has a dwindling core of survivors.
- Walking in the door to this business with an average employee compensation ticket in excess of $200,000 is a quick ticket to oblivion.
Of the large institutions only Morgan Stanley (NYSE: MS) and Goldman Sachs have announced a real change in direction. Perhaps that is because these two former investment banks have not yet quite forgotten what it is to live by their wits.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.