Update 265 — 1st Qtr Bank Profits Break Records
But Markets Skeptical: Is an Encore in Store?
With the last of the financial sector’s quarterly earnings reports for 1Q18 trickling in, we take a look at the condition of the large and diverse financial sector in the United States. What we find is a sector whose largest institutions almost all report recording-breaking if circumstantial profits. Analysts and some bank executives cast doubt though on the sustainability of the performance. Still, the banks’ performance begs the $2155-dollar question: why deregulate under these conditions?
Wall Street Gets a Tax Break, Sheds Risk
The Wall Street giants emerged from the financial crisis bigger and more profitable than ever. Over the past ten years, the three largest banks by assets — JPMorgan Chase, Bank of America, and Wells Fargo — have added more than $2.4 trillion in domestic deposits.
Net income at JPMorgan Chase, the nation’s largest bank by assets and deposits, rose 35 percent to $8.71 billion. Corporate tax cuts helped the six largest U.S. banks produce a combined net income that surpassed $30 billion for the first time ever. The new corporate tax rate has saved the six largest banks about $2.9 billion thus far, contributing a ten percent increase in quarterly net profit. The tax cuts are supposed to spur economic activity, such as lending and hiring. But loans at the four largest commercial lenders fell $2.5 billion last quarter and the combined loan count was below where it was a year earlier.
Can Wall Street Repeat?
The financial sector’s earning season that just ended makes clear the condition of its largest institutions, measured by annual profits. Along with the massive tax savings, the main factors behind Wall Street profits over the last 12 months have been:
• Trading Activity: Trading revenue was the highest in three years as they capitalized on volatile equity markets. Volatility in the markets came in and helped the equity trading. In particular, equity derivatives benefited Bank of America and others. Rising interest rates fueled revenue derived from lending. Equity trading led, with every investment bank blowing past expectations in the most volatile quarter in years — even with U.S. stocks seeing the worst single-day plunge in almost seven years in early February.
• Interest Income: JPMorgan, Bank of America and Citigroup benefited as the Federal Reserve raised rates twice in the past four months, meaning they can charge more for loans. All three firms posted higher net interest income in the first three months of the year, which they attributed to higher rates and loan growth.
• FinTech: Customers’ increasing acceptance of digital products and tools. Before online and mobile banking became popular, consumers generally opened a new account at the bank with the nearest branch; with more banking transactions done online or through smartphones, customers are picking national banks because of their well-known brands and the perception that their technology products are superior.
• Credit Quality: Credit quality remains a top concern for investors as Federal Deposit Insurance Corp. (FDIC) data shows credit-card loans reached a record last year. Bank of America and JP Morgan Chase both saw write-offs climb about eight percent, attributing the increase to souring credit-card loans. Citigroup warned that its cost of credit will likely increase in the current quarter. Regardless, all of the banks say consumer credit quality is holding up well amid low unemployment. JPMorgan had to set aside more money to cover potentially bad loans, and the bank’s total charge-off rate — the percentage of loans it expects are not likely to be repaid — climbed to 1.20 percent of all loans. That compares to 1.07 percent of loans in 2Q17.
The following might put the profit margins on Wall Street in perspective. Wells Fargo announced a one-off write-down last week of $800 million to cover losses associated with its settlement with regulators. The firm’s tax savings from the first quarter alone came to $636 million, 80 percent of Wells’ settlement charge.
Can Wall Street repeat this performance? Citigroup Chief Financial Officer John Gerspach said last week that businesses had only begun taking advantage of the changes: “I think the best is yet to come.”
Community Banks Profitability Also Up
Having locked in long term loans at favorable interest rates, big banks have also taken steps to move risk off of their balance sheets. As a result of this interest rate environment and competitive lending conditions, riskier assets have moved further down the industry as smaller, mainstreet financial institutions have “reached for yields.”
At first glance, the nation’s 5,700 community banks, with nearly $5 trillion in assets and record profits, appear to be as healthy as they have ever been. Despite record profits, there is evidence suggesting some community banks are distributing lower quality loans in search of higher yields.
Some analysts are concerned that this combined with dangerous mortgage loans could increase risk in the community banking sector. A provision in S.2155, the Economic Growth, Regulatory Relief, and Consumer Protection Act, would grant relief for banks with under $10 billion from the Volcker Rule and Qualified Mortgage safe harbor, opening the door for community banks to make riskier mortgage loans. The good news is that while individual banks may overextend themselves, community banks pose far less systemic risk than their larger counterparts.
Regional Bank Euphoria
While fewer than ten regional banks have announced their first quarter 2018 earnings reports, the results have been favorable for these institutions thus far. Comerica and KeyCorp each reported substantial increases in adjusted net income year over year. Northern Trust’s Q1 earnings totaled $381.6 million vs. $276.1 million the year prior. BB&T’s quarterly earnings are up 22 percent, compared to 4Q17.
Some institutions will see some short-term pain in exchange for long-term gain with the recognition of past tax deferrals. For instance, BMO Financial’s 1Q18 net income fell 35 percent due to the revaluation of its deferred tax asset of $425 million. This upfront charge will be more than worth it for BMO going forward as the company can now claim a significantly decreased tax rate.
If it passes the House, S.2155 is one of the biggest gifts the regional banking sector could have asked for. In raising the threshold for automatic enhanced prudential standards from $50 billion to $250 billion, the bill would allow regional banks to devote fewer resources to maintaining required capital buffers, complying with stress testing, and submitting resolution plans. In the short term, this will benefit these banks, but increased systemic risk could harm the financial system in the medium to longer term. Regional banks tend to have similar balance sheets, so while profit is strong at present, this class of banks rises and falls together.
The Sectoral Landscape
The U.S. financial sector is far more stable than it was a decade ago. Record profits, bolstered by the Republican corporate tax cut, do not appear to hide the same kind of asset bubbles, no-doc lending practices, and others risks that accompanied but went largely missed or ignored in the run up to the 2008 crisis.
The strength and stability of the financial system is thanks in no small part to post-crisis regulations. But industry lobbyists are presently hard at work taking aim at Dodd-Frank’s systemic risk protections via S.2155.
Even regulators themselves — the steadily increasing number of Trump-appointed ones at least — are not so much diligently applying lessons learned but are designing new federal rules to relax critical capital buffers, the leverage ratio, and stress testing.
More to come this week.