Big Bank Expansions Show Little to No Profit Growth or Improved Efficiency. Why?
Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
A few recent articles gained attention to the growing, albeit ever so slowly, notion that our experiment in huge banks cannot ultimately succeed, repealing the investment banking firewall of Glass-Steagall in 1999 was a mistake, and it is time to break up the largest banks.
The latest criticism of regulators coddling of big banks came from a source I have always respected, yet rarely agree with, George Will. He implicitly agreed with the idea of reigning in big banks by endorsing as Federal Reserve Chairman Richard Fisher, the current President of the Dallas Federal Reserve Bank, and well known enemy of the theory of “too big to fail.” The expansive Dodd Frank legislation could have specifically ended the era of megabanks, but in choosing to only reign in “holding companies” instead of operating companies, Dodd Frank swung, but missed on the issue.
Mr. Fisher has been chair of the Dallas Fed since 2005, and has a libertarian bent to his politics. His opus is the essay “Choosing the Road to Prosperity: Why we must end “Too Big to Fail”-- Now.” from the Dallas Fed's 2011 Annual Report. I urge anyone who appreciates impassioned and intelligent writing to read this essay, no matter what your politics.
And look what has happened since, say 2007, as the banking crisis began to unfold. JPMorgan Chase (NYSE: JPM) has grown from about $1.6 trillion in assets then by some 42% to about $2.35 trillion. Bank of America (NYSE: BAC) has grown about 24% from about $1.7 trillion to about $2.1 trillion. Citigroup (C) has actually shrunk from about $2.1 trillion in 2007 to a more recent $1.85 trillion. And Wells Fargo (NYSE: WFC) has more than doubled since 2007, when it held under $600 billion in assets. Further growth has been limited by macroeconomic conditions in recent years. If our economy had grown steadily over the past five years, I have little doubt several banks would have assets of over $3 trillion by now.
The irony is that the tremendous expansion of the largest banks has generally not been accompanied by any efficiencies or profit growth. In 2007, JPMorgan earned, without considering loan loss provisions, $22.4 billion. This year, the bank is likely to earn, pre-provision, about $21.3 billion. Bank of America earned a pre-provision $23.4 billion, and this year, might earn as much as $17 billion pre-provision. Citigroup reported about $21 billion in pre provision profit in 2007, and will earn about $22 billion this year pre provision. Finally, Wells Fargo earned pre provision profits of about $11 billion in 2007, and due to is massive Wachovia acquisition and the doubling of the bank's size, along with a great business plan, is likely to earn over $26 billion in pre-provision profits this year.
The point is of course, blind asset growth is hardly a guarantee to an increased efficiency ratio, profits, or return on assets. Much of the rationale behind the repeal of Glass Steagall firewall provisions was that the large domestic banks were being prevented from keeping up with its European and Asian rivals. Well, bank growth for growth sake is working in Europe even worse than it is in the United States.
Taking a longer view, in 1970, the five largest domestic banks held 17% of all banking assets; the 95 next largest banks held 37% of the assets, and the balance of the nation's 12,500 federal or state chartered banks held 46% of the banking assets. By mid-2012, the five largest banks held 51% of overall banking assets. The next 95 largest held an additional 36%, leaving the balance of the nation's 7,240 banks holding just 13% of banking assets. The concentration of assets is undeniable, and I tend to agree with Fisher that it is adverse to the health of our economy as a whole.
This winter the nation's banks with over $50 billion in assets will be undergoing another round of “stress tests,” starting with the nation's 19 largest banks. The parameters for this year's examination is a little different from the stress test of last year. The one thing that remains is that in order to pass, under all hypothetical scenarios, a bank must have Tier One capital of at least 5%. There will be three steps. First, conditions as they exist today. Second, conditions under a hypothetical adverse scenario entailing a recession beginning now and lasting into the first half of 2014, with real GDP declines of two percent, and unemployment rising to 9.75%. In this scenario, consumer inflation would rise to 4%, stock prices would fall 25% by mid-2013, and home and commercial real estate prices would fall by 6% and 4% respectively. Further, short term interest rates would rise to about 2.5% by late 2013, and long term U.S. Treasuries would rise to between 3.5% and 4%. Mortgage rates would rise in tandem, and corporate borrowing rates would reach 7%.
The “extremely adverse scenario” is similar to last year's test, but more severe in one key way. It assumes unemployment rising 400 basis points, GDP would fall 5% from the current level through the end of 2013, stock prices would fall 50%, and all real estate would fall 20% by the end of 2014. Short term interest rates would remain near zero through 2015, and long term Treasuries would further decline to 1.25% by mid-2013, pretty much evaporating the interest curve. Meanwhile, overseas markets would also be in upheaval and China in particular. It is that feature, a decline in China's economic status, which is new to this year's analysis.
Banks that were exceptionally strong last time around, such as State Street (STT), Bank of New York Mellon (BK), and American Express (AXP) should have no problems this time around, either. Some of the large banks that struggled with the test a year ago, who have no exposure in Asia, such as Suntrust (STI) and Fifth Third (FITB) will also pass quite easily as their capital levels have improved in the past twelve months.
The bank I expect may struggle with the new hypothetical is Citigroup. Courtesy of its prior CEO, Vikram Pandit, Citigroup in recent years has invested ever more of its resources in “emerging economies,” the largest of which is of course, China. At the close of the third quarter of this year, Citigroup had $356 billion invested in Asia, most of which is in China. So, on Jan. 7, 2013, Citigroup and its new CEO, Michael Corbat will have a decision to make; does it suggest a capital return to shareholders, and risk failing the stress test on that basis? Failing the new stress test would be embarrassing at least, given that in each report since early 2012 Citigroup has boasted of its “fortress” balance sheet.
My best guess is that Citigroup's shareholders are used to taking disappointment by now. Another year of no meaningful dividend or stock buybacks should not be that hard to take.
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