The big bankers areprojecting more bad news for their third quarter performance. A discussion of this can be found in the NewYork 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 areflection of the industry, JPMorgan Chase “warned that third-quarter tradingrevenue was likely to fall about 8 percent from a year ago. Investment banking income is also expected todrop by one-third from a year earlier.”
Note two things about thisinformation. First, the trading revenuedoes not come from the trading done by the banks, but from trading transactionsinitiated by the banks’ clients. Second,the investment banking income relates to the fees earned on acquisitions andstock and debt offerings.
As the economy recovered fromthe financial collapse, these sources of income provided an uplift for thetroubled banking industry. But, as wehave seen, the revenues from these sources can show substantial swings fromquarter-to-quarter due to the volatility of financial markets. Now, activity is down and, according to JesStaley, the head of JPMorgan’s investment bank, income from these sources couldcontinue to be down in future quarters.
No mention here of basiccommercial banking. In fact, one has togo back a substantial amount of time in order to find anything about banking onMain Street.
Oh yes, there has been thenoise about how the regulators are hurting or going to hurt bank performance byclamping down on debit card swipe fees and overdraft charges and credit cardfees, but there is little or nothing on basic banking activity, like thefinancial intermediation that connects depositors to borrowers.
Banking has become a businessof collecting fees, whether on trading activity or stock and bond offerings oron business transactions connected with private equity and other types ofprincipal investments.
The good old business ofbanking, what Leo Tilman calls “Balance Sheet Arbitrage”, is not doing so wellthese days and has been declining in importance for years. (See Leo Tilmanbook, “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 competitionand advances in the Internet and information technology, more and more bankcustomers have achieved greater access to more and more sources of to servetheir needs. As a consequence, there hasbeen a secular decline in the net interest margin banks can earn.
During this decline, in orderto earn an acceptable return on “Balance Sheet Arbitrage” banks have taken onriskier loans, mismatched maturities, collected more and more fees, and usedgreater 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 thefederal government for the past 50 years. However, this bubble has burst…at least, for the time being.
The pressure on bank netinterest margins will continue into the near future if the Federal Reservekeeps interest rates at their current lows for the next two years. Adding a new “operation twist” to cause longterm interest rates to fall further will only exacerbate the interest spreadsearned 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 feesources, banks will be forced to expand further into two other areas thatTilman has defined: Principal Investments (direct private equity and venturecapital stakes, investments in hedge funds private equity stakes, or capitalallocations to other proprietary investment opportunities) and Systematic RiskVehicles (taking various risk positions in interest rates, credit, mortgageprepayments, currencies, commodities and equity indies).
I would like to make twocomments about these developments. First, the trends described here are only going to benefit the largerbanks. Most of these activities taketrained and experienced individuals that achieve scale economies by beinggrouped in financially sophisticated organizations.
Smaller financialorganizations cannot afford to hire such expertise and cannot afford to buildthe departments that will house them. When the smaller banks have tried to expand their businesses toincorporate these other sources of revenues they generally have gotten in wayover their heads and have caused tremendous damage to institutions.
An example, even from the1990s: 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 theboard of directors, allowed the bank’s financial officer to engage intransactions that should only be done in the most sophisticated financialorganization. And, the bank only had oneperson, not that well trained, to conduct such sophisticated transactions. Nowonder it was a troubled bank.
Smaller banks, with netinterest margins continually squeezed, will not be able to generate sufficientearnings to compete with their larger brethren.
Furthermore, banks are goingto become less people intensive and will become driven more by informationtechnology. We are seeing the start ofthis…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 becauseit is just reducing staff levels that were inflated otherwise. The future, bank staffs are going to be cuteven further as information technology takes over the banking industry.
The future? Look two places: the first is the directionof banking in many emerging countries; and second, look at what your kids andgrandchildren are doing. Finance is justinformation. For one, we don’t needmassive branch systems to exchange information. My children go into a branch, maybe once ortwice a year…at most…and this reluctantly. Their kids? Don’t bet on themusing physical banking facilities…anywhere. And, look at the emerging nations with poor, spread out populations thathistorically have been under-banked. Itis truly remarkable the inroads that electronic banking is making in theseareas.
I also believe that this secondtrend will be captured by the larger banks who again can scale up theirefforts, both in terms of size of operation and in terms of technicalsophistication, far better than can the smaller banks in the country.
Basic banking, what Tilmancalls “Balance Sheet Arbitrage” will continue to exist but in new forms andwith changed margins. But, the remainingbanks 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 “BalanceSheet Arbitrage” activities to protect them, as the British have suggested doing,will not change the direction that banking is going.
The question is “Do BankersGet It?”
