Wall Street Banks Are Back?

Includes: BAC, C, GS, JPM, MS, WFC
by: John M. Mason

In terms of reporting profits, this was a good week for the largest banks in the United States.

The largest six banks in the United States reported earnings of $23.1 billion, which brings them back into the heydays of 2006 and 2007. The largest six banks are JPMorgan Chase & Company (NYSE:JPM), Bank of America Corporation (NYSE:BAC), Citigroup Inc. (NYSE:C), Wells Fargo & Company (NYSE:WFC), Goldman Sachs Group Incorporated (NYSE:GS), and Morgan Stanley (NYSE:MS).

However, the average return on equity of these banks was a little over 9 percent, less than half of what it was in that earlier period.

Furthermore, with the exception of one of the six banks, Wells Fargo, the returns were not produced primarily by the fundamental banking business.

Looking through the reports released over the past ten days, one sees these results produced by lower expenses, release of loan loss reserves, reduced litigation expenses connected with the treatment of mortgage loans, fees earned on trading and advice on mergers and acquisitions, and other investment banking services.

Loans are increasing, but at relatively modest rates, and with the low interest rates being earned on these loans, the lending portfolio is providing little boost to what has been earned.

These six organizations control slightly less than $10 trillion in total assets.

If one drops down a little further and reviews some of the results of the "regional" banks, those banks that are smaller than the top six in asset size but are still within the top twenty largest banks in the country, one gets a similar story.

Note, however, the difference in size between the six largest organizations and what follows. JPMorgan, of course, leads the pack with assets around $2.4 trillion. The sixth largest institution, Morgan Stanley, controls only about $0.8 trillion in assets. But, the seventh and eighth largest banking institutions, Bank of New York Mellon Corporation (NYSE:BK) and U.S. Bancorp (NYSE:USB), have less than $0.4 trillion in assets.

These "regional" banks are less diversified than the "too big to fail" banks and so tend to rely more on the basic business of banking to produce their results. However, looking at the second quarter reports of some of these institutions, one also gets a mixed bag of where their profits came from.

As with some of the larger banks, profits were boosted because of events not tied to banks' basic banking business, things like the reduction in provision for loan loss reserves, one-time gains, fees on trust services, and equity investment returns.

Other things are happening in the banking industry that are keeping indicators like return on equity at low levels. For one, banks are being required to achieve higher capital ratios. Furthermore, loan-to-deposit ratios have dropped from over 100 percent in the 2006-2009 period to levels that were achieved in the early 1980s. Both of these factors impact revenue streams and therefore reduce measures like the return on equity.

A problem resulting from this performance is that people in the US Congress are beginning to put more pressure on the regulatory system to be "tougher" on these banks. Producing such profits draws the attention of those wanting to impose more regulation on the banks…especially on the Wall Street banks…and this, combined with the fact that the bankers are being so vocal in their fight to protect the banking industry from more and more rules and regulations, paints a picture of the "greedy bastard", the banker that is raking in all sorts of money, left and right, and yet crying that are being misused and abused.

What is missing in this argument is that a great deal of the profit being earned by the largest twenty-five domestically chartered banks in the United States is that the earnings of these financial institutions are not coming primarily from the fundamental banking business. The results are being achieved from a multitude of reasons, none of them connected specifically with sustainable business performance.

A major portion of the earnings is coming from things like reductions in litigation expense, reversals in loan loss provisions, and the cutting of expenses.

Congress and the regulators should not "rush in" and strong-arm more and more regulation because of the types of earnings that are now being posted by the banking industry, especially by the largest institutions.

The earnings being posted are "good stuff" and will contribute to a stronger banking industry in the future. But, the banking industry must start to earn a larger and steadier part of its profits from fundamental banking operations.

This is needed not only for the health of the banking industry, but also for the general health of the economy and economic growth.

A substantial part of the profits of the largest banks, however, will come from non-traditional commercial banking areas. Personally, I don't want to bank with just a "traditional" commercial bank…and I don't. I guess in my perfect world, I would see the "financial" industry breaking up into fewer and larger commercial banks, credit unions, and many other "alternative" financial institutions that do not accept deposits like money market funds, hedge funds, and structured investment vehicles.

Like the economy itself, I believe that the financial industry is going through a major period of restructuring. I have written a fair amount about my belief that the United States economy is going through the painful process of a major restructuring. I believe that the financial system is also going through such a process.

Regulation always tends to be aimed at what happened, not what is going to happen. Between the changes that are taking place in information technology, the changes that are taking place in the global economy, the changes that are taking place in the economy, itself, and the changes that are taking place in the mindset of the culture, the future of the financial system is hard to picture. For Congress and the regulatory agencies to impose incomplete ideas about what needs to be done to prevent a repeat of the 2007-to-2009 financial collapse is absurd!

The economy is working itself back into shape. The financial system is working itself back into shape. But, these take a substantial amount of time to achieve. Too much tinkering around with the system will only place impediments in the road to gaining the brave new world we are heading for. If I would recommend anything in this environment it would just be connected with institutions providing more information and more transparency relative to what they are doing.

Wall Street banks are not back…but they are getting there.

Disclosure: I 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.