Okay, so I stole the headline from a May 5, 2012, Economist article on banks, The Not-for-Profit Sector: Are regulators striking the right balance between safety and profitability? It’s a good question. It does seem like financial institutions, particularly investment banks, seem to stumble from one fiasco to another every few years, ergo the bankers are in need of regulation by “enlightened” regulators. (Heh. Funny. As if anyone can prevent booms and busts, much less know when that boom is about to go bust; that is why I get a kick out of federal gub’ment’s The Office of Financial Stability. The name is positively Orwellian.) And now that banks will have to hold more liquid assets, more equity, and stop risky activities (although profitable activities), such as proprietary trading, it’s a fair question.
Then consider what a ship wreck banks have been in this century. From October 2003 through yesterday, the KBW Bank Index declined by almost 30%. The Dow Jones Industrial Average in that period? Why, it returned 70%. (And still retail investors are selling domestic equity funds. Typical. Buy on the high, sell on the low.) Over the last three years, by the way, the KBW Bank Index eked out a 5% or so return—versus a 35% gain by the Dow. So, bank stocks suck, right? They are doomed, and face over-regulation; profit margins have been falling . . . stay away. Right?
Well, what’s up? In the trailing 12 months, the KBW Bank Index has returned about 30%. What’s going on? Enter Richard Bove, VP of equity research at Rochdale Securities. Says he:
“Investigating the Numbers
Perhaps the most frustrating problem that I find when analyzing banks stocks is the constant conflict between reality and concept. People in the media are convinced that banks are not making money. A large number of investors believe these companies make money but only because they are eliminating loan loss reserves. Others, looking at the industry, argue that if one focused on core earnings the banks would not be making enough money to pay for their cost of capital.
“Therefore, I decided to look at bank revenues and profits in a number fashions to determine whether banks were earning real profits and their cost of capital. The data used was gathered from the FDIC-Insured quarterly bank. The period reviewed was from 2006 to 2012 Q2. My conclusion is that banks are both earning money from their core operations and that they are, in fact, earning their cost of capital.
“Reported Data
Let’s start with the reported net income data. It is impressive. Bank earnings in the second quarter of 2012 posted the thirteenth quarter in a row of higher earnings on a year over year basis. In absolute terms profits were the 8th highest in the history of the industry. However, if one adds back the big trading losses from JPMorgan Chase (JPM/$41.77/Under Valued), this may have been the highest profit quarter in the history of the banking industry.”
Okay, I’ll agree that GAAP net income is a fiction, or can be. But I wonder if Bove isn’t over-reaching in his argument that banks beat their cost of capital by the way he strips out nearly everything in his definition of core revenue. Basically he strips out everything (investment banking, venture capital fees, mortgage servicing, securitization income) and other “on balance sheet asset sales.” Oh, and he also strips out “other,” such as accounting shenanigans, including debt value adjustments, one-time sales of business.
I have always had trouble reading the balance sheet of financial institutions, and I get that Bove is trying to focus on banks’ core business: net interest income and recurring revenues (deposit service chares, trust income and insurance commissions). Bove calculates that “core banking revenues have, in fact, risen sharply since before 2008.”
So, to drill down to what a bank is really making, you add in expenses and taxes. Even if you include actual net loan losses (ignore loan loss provisions; they are not real, he says), Bove says, “core earnings are in a sharp uptrend.”
He also says, “The industry is more than earning its cost of capital.” He shows that based on core income is nearly 2.5 percent over banks’ cost of capital (the quarterly annualized ROE/10-Year Treasury yield).
He concludes: “The bank industry is earning a great deal of money. Anyone who claims it is not simply has not done their homework.”
The Economistmagazine wonders, Can banks “attract investors with a combination of utility-like returns and bank-like volatility.” The magazine says that “most big banks are still forecasting (or at least aiming for) returns on equity of 12-15%, which would handily cover the cost of their capital.” It concludes: Cost cutting is key to attract investors.