The State Of The Global Banking System

by: Remy Raisner, CFA

For years, Western economies have been binging on debt. So much that their banking systems are still hung over, and their recovery is shaping up to increasingly resemble a multi-year hiccup with consecutive ups and downs.

As Europe is trying to avoid its 'Lehman moment', obvious challenges, but also some opportunities, have arisen from the current state of the world's financial system.

In North America, some banks are still badly bruised, and Bank of America (NYSE:BAC) is the institution with the most to sort out. It has been struggling to turn itself around from the drags created by the acquisition of mortgage lender Countrywide Financial in 2008, lawsuits related to real estate foreclosure practices and public-relation snafus created by an attempt to charge a $5 monthly debit card fee to its customers (a plan that was eventually scrapped).

Overall, third quarter results across the Street have been weak and down from the previous quarter. Bank of America churned out a profit, but that was mostly due to asset sales and an accounting gain -what is fairly representative of current earnings on Wall Street.

Amid the sluggish economy, banks have faced slow loans demand and a dearth of strong enough borrowers, as well as a sharp decline in M&A activity and a decrease in asset values. Trading profits have been more difficult to generate as of lately, as most asset classes have been highly correlated given macroeconomic events, what pushed many investors to hold off trading in and out of positions. That caused volumes to fall and market liquidity to weaken. In addition, tighter government control of the banking system and pressures to recapitalize balance sheets has led to losses on assets banks hurried to sell. Even though the industry is profitable again, CEOs of the financial industry are turning pessimistic about growth, to the exception of J.P. Morgan's CEO Jamie Dimon.

The Federal Reserve's Operation Twist has hurt financial institutions' results as well. They have been squeezed by the move in the yield curve, as they borrow short-term and lend long-term.

While Morgan Stanley (NYSE:MS) posted a profit in the third quarter (much of it however due to an accounting gain, like Bank of America), J.P. Morgan (NYSE:JPM) saw its profits decline for the first time in 3 years. Goldman Sachs (NYSE:GS) posted a loss, its second since going public in 1999 and its first since the Lehman Brothers bankruptcy crisis of 2008. All banks are letting go of employees: Citi (NYSE:C) announced the elimination of 900 jobs in its investment banking division and 4,500 across the entire firm. Goldman Sachs is in the process of suppressing 1,000 positions. Bank of America will lay off 30,000 employees.

The third quarter 2011 has witnessed some structural changes in the financial industry. J.P. Morgan passed Bank of America to become the largest U.S. bank by total assets. Wells Fargo (NYSE:WFC) became the largest U.S. bank by market capitalization.

Most noticeably, the third quarter on Wall Street was marked by the big scare created by the high profile bankruptcy of commodities brokerage firm MF Global, which was due to a leveraged bet on European sovereign debt that went sour. 33,000 customers accounts were frozen and a frenzied search for client funds took place. The events have been deemed all the more puzzling because of their occurrence after the financial crisis of 2008 and the bankruptcies of Lehman Brothers and AIG.

Wall Street bonuses are not surprisingly forecasted to be lower this year, if not nonexistent at certain firms. An executive search firm has predicted them to drop between 35% and 40% on average, and total compensation is predicted to decline 30%.

Nevertheless, financial institutions in Europe have fared worse. Given the crisis of the euro zone, bank failures fears are high, and the world's major central banks recently undertook a joint effort to provide cheap U.S. dollar loans to dollar-starved European institutions. Even though this action does not address long-term issues, it reassured investors in that it showed that major central banks officials are ready and willing to fight the euro zone crisis hand-in-hand.

European banks have suffered from similar issues as their U.S. peers and have had to hoard cash, recapitalize their balance sheet and cut costs too -albeit at a more hurried pace, given their larger exposure to European sovereign debt. Even strong European banks are currently frozen out of funding.

In Europe, in addition to the current political threats to the banking system, threats lie in the toxic assets still present on banks' books. U.S. financial institutions have been faster to purge themselves, whereas European banks still hold more of the likes of subprime securities, CDOs, leveraged loans and U.S. commercial real estate loans.

Globally, investment banking revenues decreased sharply in the third quarter. According to Thomson Reuters, they are 36% less than in the second quarter of 2011, with equity and debt capital market fees dropping 55% and 46% respectively.

Banks will keep facing the uncertainty of the total bill they will have face over wrongful foreclosure practices litigation. Besides, the U.S. government announced in September that it would sue 17 of the world's largest financial firms for having misrepresented the quality of the mortgages they sold to Freddie Mac and Fannie Mae for $196 billion. And regulators are far from being the only party suing banks over mortgages issues.

While there has been widespread outcry and popular protests among taxpayers against banks since their government bailouts in 2008, dissatisfaction seemed to have increased in the second part of this year. Part of the public has called for financial institutions and their executives to be reprimanded more severely for their role in the financial crisis, as the Occupy Wall Street movement has testified. Public anger has even led organizers to create a 'Bank Transfer Day' on November 5th, on which large banks customers were asked to withdraw their deposits.

On a brighter note, U.S. banks are overall reasonably healthy now. They have rebounded from their 2008-2009 lows. Their exposure to European sovereign debt is limited, even though their exposure to contagion from a crisis of European banks could be more worrisome. The Great Recession and the evolution of the banking system both domestically and worldwide has created opportunities. Certainly, banks will most likely shrink and revert to a more 'boring' model, relying more on customers' deposits and less on leverage and wholesale funding (repurchase agreements), which dried up in 2008. But new banks will most likely appear, grow and become major actors of the industry, and U.S. banks will be able step up lending where European banks reduce their activities, both domestically and worldwide.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.