Dodd-Frank And Its Impact On Big Bank Revenue

| About: Financial Select (XLF)

The Financial sector started to rally about a month before the Presidential election, with the results of the November 8th election sending the sector even higher, for its best rally since 2013.

The election catalyst with the Republican Congress and Presidency being under one umbrella, was that Dodd-Frank was likely to be significantly neutered, allowing the banks and brokerage houses to breathe once again.

Here is how the Financial sector has performed in terms of sector earnings and revenue growth in the last several years:

Financial Sector Big Banks
Y/Y Y/Y
Financial Financial JPM BAC WFC
Earnings rev gro rev gro rev gro rev gro
q3 '16 8.6% 6.9% 2019 est 6.0% N/A 4%
q2 '16 -4.0% 0.9% 2018 est 4.0% 5.0% 3%
q1 '16 -10.4% -1.2% 2017 est 4.0% 2.0% 3%
q4 '15 2.5% 2.7% 2016 est 0.0% 1.0% 2%
q3 '15 7.9% 1.0% 2015 -1.0% -1.0% 1%
q2 '15 18.5% 4.6% 2014 -2.0% -4.0% -3%
q1 '15 16.1% 4.1% 2013 0.0% 3.0% 6%
q4 '14 -3.3% 0.7% 2012 0.0% -8.0% -5%
q3 '14 16.3% 5.0% 2011 -5.0% -15.0%
q2 '14 -6.6% 0.8%
q1 '14 -0.6% -1.9%
q4 '13 24.7% -10.9%
q3 '13 1.5% 0.2%
q2 '13 30.0% 6.2%
q1 '13 18.2% 4.1%
q4 '12 17.4% 20.7%
q3 '12 7.4%
q2 '12 63.3%
q1 '12 13.6%
q4 '11 4.9%
Source: Thomson Reuters Proprietary Research
Click to enlarge

While the Financial sector in its entirety doesn't look that bad, the "average" revenue growth for the sector, the past 16 quarters, including Q4 '12, has been 2.7%. The "average" sector earnings growth since Q4 '11 isn't bad at all, over 11%.

However, the big banks are another story.

Only one year in the last 5 have Bank of America (NYSE:BAC) or Wells Fargo (NYSE:WFC) had a positive year of revenue growth and that was 2013, which was a year that the S&P 500 was up 32%. In the last 5 years, the best JPMorgan (NYSE:JPM) could do was a flat growth in revenue.

The initial talk out of Washington is that FSOC's (Financial Stability Oversight Council) "too big to fail" and SIFI (Strategically Important Financial Institution) will be amended or repealed completely.

Again, per one source, and it is still very early, the CFPB is also on the block.

As someone who graduated from college just as the banks were being deregulated (1982) under the Reagan Administration, people don't realize what an enormous job creator the Financial sector was in the 1980s and 1990s. Investment services, credit cards, mortgages, the big banks became all-purpose financial service providers as many still are today.

When 2008 struck, the Financial sector was probably peaking anyway in terms of two decades of secular growth and Dodd-Frank was enacted (in my opinion) at the worst possible time.

Another fun fact about Financials is that of the S&P 500, 64 stocks are Financial companies. Prior to the spin-off of Real estate in its own sector, which is 28 companies, Financials were 18% of the S&P 500.

Financials still contribute roughly 13% of the operating earnings contribution of the S&P 500, per Howard Silverblatt's work at Standard & Poor's.

Analysis / conclusion: The Financial sector holds a unique position in the S&P 500 in terms of its importance to the US economy. Ben Bernanke once referred to the Bank / Finance as analogous to the human heart in terms of the US economy: it collects savings from households, and distributes to borrowers throughout the US and global economy much the same as the human heart aggregates and distributes blood to the human body. In the last 8 years banks have been forced to hold more capital against less risk, and have been able to generate significantly less revenue growth than at any time in the last 30 years.

And maybe that is a good thing. However, the way the big banks and financial service companies have traded the last 8 years, they act like they are "oxygen-starved" and the lack of revenue growth proves it.

However, Alan Greenspan said way back in 1996, "you can't have a system where the profits accrue to the private sector shareholders and the losses are borne by the public sector" which exactly explains the bank crises of the last 30 years.

But in my opinion you also cannot have what Jeremy Grantham proposed after 2008, when he said the Federal Reserve should have "ordered" the banks to raise capital (issue dept or equity) in 2007. Then the US banking system becomes like the Chinese banking system: a "command-and-control" banking system run by government decree which private shareholders would flee in a heartbeat.

In my opinion the roots of the 2008 Financial Crisis were truly bipartisan: it started with Clinton - Janet Reno initiative in the early to mid-1990s from which the 1930s maxim "a chicken in every pot" became a 'home on every balance sheet" which really put the banks in a pickle, particularly in larger urban areas. Combined with Graham-Leach-Bliley Act which passed in 1999, which repealed Glass-Steagall and allowed the large brokers and investment banks to lever up with debt, the proverbial welding torch to a parched forest (or an already overheated housing market), was 9/11, which forced Greenspan to lower the Fed Funds rate again, to near zero.

By the time the alarm bells started going off in late 2006-early 2007, the financial system was so choked with bad paper, very little could have saved it.

And then the single-family housing market peaked with Hurricane Katrina in August 2005. So, from the peak of the housing market in August '05 it still took 24 months for the first problems to surface in August 2007.

My own opinion is that banks should be allowed to fail and any rescue can't contain public, taxpayer money. However, that is overly simplistic and does not account for systemic risk.

Given the tenor of the commentary around Dodd-Frank coming from Washington, 2017 could be the best year for the Financial sector in many years, at least since 2013.

Watch revenue growth - that will be the key tell for the bigger banks.