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” (http://www.nytimes.com/2011/09/14/business/wall-street-banks-bracing-for-drop-in-trading-revenue.html?_r=1&ref=business)
In what is taken as a
reflection of the industry, JPMorgan Chase “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 http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman.)
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. (http://seekingalpha.com/article/292446-will-bernanke-policy-destroy-credit-creation)
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. (http://seekingalpha.com/article/292286-will-bernanke-policy-destroy-credit-creation-bill-gross-is-worried-it-will)
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 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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