|Satyajit Das: The Truth About Bank Earnings|
Can the improvement in bank stocks actually be sustained?
Despite a mixed earnings report for Q4 2013, US banks are up by over 200%, playing a key role in the global stock rally.
Interestingly, no one seems to be that interested in either the source of their profits or their actual future prospects with sell-side analysts showing a mind-numbing focus on beating massaged earnings expectations.
Measures taken by central banks -- especially low interest rates policies and large liquidity flows (aka quantitative easing) -- have underpinned bank earnings to a large degree. Low short-term policy rates act as a de facto subsidy to banks.
A simple analysis focusing on what the banks could be earning illustrates their fundamental position. Banks can take their deposits attracting near-zero rates and invest in risk-free government bonds to generate carry income.
Assuming it could earn a net spread between US Treasury yields and deposit rates of 2.00%, JPMorgan (NYSE:JPM) would earn around $26 billion on its deposits of $1.3 trillion without engaging in any banking activities. This is roughly the same as its actual 2013 pre-tax earnings of around $26 billion. This net carry on deposits equates to around 97%, 138%, and 60% of Citibank's (NYSE:C), Bank of America's (NYSE:BAC), and Wells Fargo's (NYSE:WFC) pre-tax 2013 earnings respectively.
US banks also benefit from $2.4 trillion excess reserves, resulting from the central bank's QE programs. At the current rate of 0.25% per annum paid by the Federal Reserve, this equates to an additional $6 billion in earnings.
In a 2013 study, McKinsey Global Institute found that between 2007 and 2012, interest rate and QE policies resulted in a net transfer to US financials of $150 billion from households, pension funds, insurers, and foreign investors.
Monetary policy also boosts bank earnings indirectly. Low rates have stimulated a recovery in the US housing market, boosting income through higher refinancing volumes. Low rates have helped the values of mortgage-backed securities and other risky assets recover, improving earnings. Low rates also allow vulnerable borrowers to carry high debt levels, reducing levels of non-performing loans.
But there are significant risks.
As banks become instruments of policy by holding greater levels of government securities, deterioration in sovereign quality or rising interest rates expose them to the risk of large losses. The increase in interest rates following the suggestion of a "taper" in the bond-buying program of the US Federal Reserve may have resulted in losses of around $17 billion to US banks alone.
The earnings from current bank policies also disguises fundamental earnings problems.
Lower loan volumes, reflecting widespread deleveraging by corporations and consumers and reduced economic activity, will limit earnings growth. Corporations are increasingly choosing to finance directly in capital markets, further reducing loan volumes and earnings.
After 2007/2008, trading revenues remained robust as volatility and portfolio adjustments fed volumes and profit opportunities. But as the broader economy stagnates, trading volumes have declined. Proprietary trading is now restricted or attracts high capital charges, reducing its contribution to earnings. Derivatives revenues will be affected by the migration of activity to central counterparty clearing houses and a clearing model.
Income from advisory work, mergers and acquisitions, new debt, and equity issues is below pre-crisis levels, reflecting less activity as well as competition from smaller boutique firms and internalization of this work within large corporations.
Bad and doubtful debt-provision reversals, which have been significant, are non-recurring items. JPMorgan's 2013 credit provisions fell by around $3 billion from 2012 (93%). Citibank, Bank of America, and Wells Fargo also reduced credit provisions in 2013 by $2.8 billion (25%), $4.6 billion (56%), and $4.9 billion (68%). The US Office of the Comptroller of the Currency has expressed concern that the industry is using lower loss reserves to increase reported earnings.
Banks also face higher wholesale funding costs, which affects margins but also their ability to stay competitive as cost-effective finance providers.
Banks also face potential write-downs of goodwill on expensive acquisitions. They may also have to write off deferred tax assets (resulting from losses) if they cannot be used in a timely fashion.
Litigation costs remain a major uncertainty. Rating agency S&P estimates that the biggest US banks alone may have to pay a further $104 billion to resolve US mortgage-related legal issues. There are likely to be additional costs from the various rate-manipulation cases.
Banks face greater compliance and regulatory costs. Higher capital levels, reduced leverage, and requirements to hold more prime-quality liquid assets combined with higher costs of capital will reduce earnings and returns on equity. Returns on equity have fallen sharply to high single-digit or low double-digit figures, well below the pre-crisis 20% returns.
Complicating the outlook is the growing complexity of banks' reported earnings. Opaque and subjective adjustments for items like Funding Value Adjustment (FVA), reflecting the banks' borrowing costs to fund collateral lodged when hedging an uncollateralised trade with an offsetting collateralized position, or Debt Value Adjustment (DVA), reflecting changes in the value of a bank's own debt) make it difficult to evaluate a bank's actual financial performance.
It will be interesting to see whether the improvement in bank stocks can actually be sustained.
No positions in stocks mentioned.
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