Bankers Expect Weak Profit Performance in the Future

The big bankers are projecting more bad news for their third quarter performance. A discussion of this can be found in the New York Times article “Banks Brace for a Season of Fall-Offs”.

In what is taken as a reflection of the industry, JPMorgan Chase (JPM) “warned that third-quarter trading revenue was likely to fall about 8 percent from a year ago. Investment banking income is also expected to drop by one-third from a year earlier.”

Note two things about this information. First, the trading revenue does not come from the trading done by the banks, but from trading transactions initiated by the banks’ clients. Second, the investment banking income relates to the fees earned on acquisitions and stock and debt offerings.

As the economy recovered from the financial collapse, these sources of income provided an uplift for the troubled banking industry. But, as we have seen, the revenues from these sources can show substantial swings from quarter-to-quarter due to the volatility of financial markets. Now, activity is down and, according to Jes Staley, the head of JPMorgan’s investment bank, income from these sources could continue to be down in future quarters.

No mention here of basic commercial banking. In fact, one has to go back a substantial amount of time in order to find anything about banking on Main Street.

Oh yes, there has been the noise about how the regulators are hurting or going to hurt bank performance by clamping down on debit card swipe fees and overdraft charges and credit card fees, but there is little or nothing on basic banking activity, like the financial intermediation that connects depositors to borrowers.

Banking has become a business of collecting fees, whether on trading activity or stock and bond offerings or on business transactions connected with private equity and other types of principal investments.

The good old business of banking, what Leo Tilman calls “Balance Sheet Arbitrage”, is not doing so well these days and has been declining in importance for years. (See Leo Tilman book, “Financial Darwinism” and my review of it. As financial market efficiency has improved through increases in competition and advances in the Internet and information technology, more and more bank customers have achieved greater access to more and more sources of to serve their needs. As a consequence, there has been a secular decline in the net interest margin banks can earn.

During this decline, in order to earn an acceptable return on “Balance Sheet Arbitrage” banks have taken on riskier loans, mismatched maturities, collected more and more fees, and used greater amounts of financial leverage. Adding risk in this way was supported by the credit inflation policies of the federal government for the past 50 years. However, this bubble has burst…at least, for the time being.

The pressure on bank net interest margins will continue into the near future if the Federal Reserve keeps interest rates at their current lows for the next two years. Adding a new “operation twist” to cause long term interest rates to fall further will only exacerbate the interest spreads earned by commercial banks and will perhaps stifle lending even further.

If these conditions continue, and regulations continue to put downward pressures on many profitable fee sources, banks will be forced to expand further into two other areas that Tilman has defined: Principal Investments (direct private equity and venture capital stakes, investments in hedge funds private equity stakes, or capital allocations to other proprietary investment opportunities) and Systematic Risk Vehicles (taking various risk positions in interest rates, credit, mortgage prepayments, currencies, commodities and equity indies).

I would like to make two comments about these developments. First, the trends described here are only going to benefit the larger banks. Most of these activities take trained and experienced individuals that achieve scale economies by being grouped in financially sophisticated organizations.

Smaller financial organizations cannot afford to hire such expertise and cannot afford to build the departments that will house them. When the smaller banks have tried to expand their businesses to incorporate these other sources of revenues they generally have gotten in way over their heads and have caused tremendous damage to institutions.

An example, even from the 1990s: when I was brought in to turn-around a smaller bank during the nineties, I was shocked to find that the investment policy of the bank, approved by the board of directors, allowed the bank’s financial officer to engage in transactions that should only be done in the most sophisticated financial organization. And, the bank only had one person, not that well trained, to conduct such sophisticated transactions. No wonder it was a troubled bank.

Smaller banks, with net interest margins continually squeezed, will not be able to generate sufficient earnings to compete with their larger brethren.

Furthermore, banks are going to become less people intensive and will become driven more by information technology. We are seeing the start of this…Bank of America (BAC) reducing staff by 30,000 and HSBC laying off 40,000. Other banks are also downsizing staff. But, in my view, this is just a start because it is just reducing staff levels that were inflated otherwise. The future, bank staffs are going to be cut even further as information technology takes over the banking industry.

The future? Look two places: the first is the direction of banking in many emerging countries; and second, look at what your kids and grandchildren are doing. Finance is just information. For one, we don’t need massive branch systems to exchange information. My children go into a branch, maybe once or twice a year…at most…and this reluctantly. Their kids? Don’t bet on them using physical banking facilities…anywhere. And, look at the emerging nations with poor, spread out populations that historically have been under-banked. It is truly remarkable the inroads that electronic banking is making in these areas.

I also believe that this second trend will be captured by the larger banks who again can scale up their efforts, both in terms of size of operation and in terms of technical sophistication, far better than can the smaller banks in the country.

Basic banking, what Tilman calls “Balance Sheet Arbitrage” will continue to exist but in new forms and with changed margins. But, the remaining banks will have to rely more and more on “Principal Investments” and “Systematic Risk Vehicles” and fees to generate adequate returns. Putting a “ringfence” around the “Balance Sheet Arbitrage” activities to protect them, as the British have suggested doing, will not change the direction that banking is going.

The question is “Do Bankers Get It?”

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