This is a guest commentary by Christopher Whalen. It was originally posted on Institutional Risk Analyst.
Source: David Shankbone
This week brings the start of Q1 2017 earnings for many banks, large and small. In order to better inform the subsequent prognostications, we borrow a line from the Passover Seder and ask: why is this bank different from all other banks? This question is not only important to understanding bank financial performance and earnings, but also to appreciate the subtleties of the evolving regulatory narrative in Washington around big banks and “too big to fail.”
Last week, White House economics czar and former Goldman Sachs President Gary Cohn let it be known that the Trump Administration was considering legislation that would separate the retail banking business from institutional and investment banking. In very simplistic terms, this would equate into spinning the old Chase Manhattan Bank out of JPMorgan (NYSE:JPM) or requiring Bank of America (NYSE:BAC) to sell Merrill Lynch.
Does anybody in Washington understand how complex and disruptive it would be to impose such a separation? We doubt it. The kerfuffle about breaking up the big banks makes for breathtaking news copy, yet in practical terms this is not easy or even practical to achieve. For one thing, the much beloved retail business is not particularly profitable, but would require a lot of capital support because of its size.
The second issue is that the institutional part of the bank, including over-the-counter (OTC) derivatives, also requires a lot of capital on a risk weighted basis, making the actual act of separation considerably more difficult that just discussing it in front of a group of astonished members of the Senate. The big banks certainly are a government-protected monopoly, but they are also public utilities that provide essential services to the US economy. Mess with that in the wrong way and you’ll take points off of GDP before you see any benefits.
Let’s take a look at some numbers to get an idea of what’s involved in separating the different pieces of some of the largest banks. The columns below show the total assets of the banking group, the assets of the subsidiary banks, the ratio of Economic Capital to Tier 1 Risk-Based Capital (T1RBC) for the banking business, and risk adjusted return on capital (RAROC), all taken from regulatory disclosure and the TBS Bank Monitor.
Source: FDIC, FFIEC, Total Bank Solutions
The Trouble With Big Banks
Economic Capital or “EC” measures risk and describes how much capital a bank would need to cover its obligations in three buckets, lending, trading and investing, during a stressed scenario like 2008. Most little banks have too much capital, thus the ratios of EC to T1RBC tend to be less than 1. The big zombie banks tend to cheat when it comes to risk and thus have too little capital, but not for the reasons that people like Minneapolis Fed President Neel Kashkari believe.
The trouble with the biggest banks is not the absolute level of capital, but the poor profitability and equally poor disclosure of risk. Like the large automakers, the big banks do not really generate enough profits over the long-term to meet their cost of capital. Thus big banks have EC to T1RBC ratios well-above 1. They are also forced into aggressive stock repurchase cycles to placate institutional equity investors, making it impossible to retain capital.
Nominal equity returns in high single digits don’t get it done when your cost of capital is in the teens, but even more revealing is looking at the zombie banks in terms of risk-adjusted return on capital or RAROC. This measure is simply net income divided by Economic Capital, but it is quite revealing in terms of understanding bank business models and behavior. Big banks tend to be in low single digits on RAROC, while smaller banks routinely have RAROCs in the teens or much higher.
The story that these numbers tell is important for investors, firstly because the business models of these top institutions are very different. JPM, BAC and Wells Fargo (NYSE:WFC) have the vast majority of their assets “in the bank,” to recall the immortal words of Angelo Mozilo to CNBC’s Maria Bartiromo around 2007. We recall that discussion as though it were yesterday because it told us that the trouble was coming. Countrywide was soon sold to its warehouse lender, BAC, which had long coveted Mozilo’s mortgage banking operation. The rest is history….
Today the top universal banks tend to operate most of their retail and institutional businesses in the bank, making any separation like removing selected organs from a living body. In order to actually divide the retail from the institutional businesses, you’d need to create a brand new platform to house one of these silos. Think of surgically removing an implanted alien from Lt. Ripley's chest and you get the idea. Trust us when we say that such a change is not the sort of thing to be handled quickly by federal regulators.
The lowest RAROC of the group is JPM, which has an enormous amount of trading risk housed in its banking units. While JPM’s bank units collectively have about $200 billion in T1RBC today, the TBS Bank Monitor model calculates that JPM needs over half a trillion dollars in EC to survive a stressed scenario, this largely due to the big trading exposures and the bank’s OTC derivatives book. So if you really want to split up the retail and institutional sides of JPM, you’d probably need to raise additional capital – and lots of it.
WFC generates an equally large EC number to that of JPM, but for very different reasons. The largest component of risk for WFC is securities investments, nearly $325 billion of the $384 billion in EC calculated for the bank units of this largely domestic bank holding company. Lending is actually less than 20% of the EC number for WFC and trading risk is miniscule. Thus the key point is that WFC and JPM are very different businesses – but neither is very profitable in terms of nominal equity returns much less RAROC.
Likewise, BAC generates an EC number of $438 billion vs its T1RBC of $153 billion, again mostly due to securities investments held by the bank’s investment portfolio. The bank’s lending and trading operations account for just a quarter or $100 billion of the EC calculation. And again, the 3% RAROC is nothing to brag about.
When we get to Citigroup (NYSE:C), however, the $361 billion in EC is divided about equally between trading and securities investments, like JPM owing to the large derivatives operation. Citi also has the smallest retail business of the top four universal banks, being now mostly a wholesale bank after the sale of the asset management and mortgage servicing segments.
Looking at U.S. Bancorp (NYSE:USB), the most highly valued of the top US banks, the risk profile is very similar to that of BAC and WFC. Most of the risk in the EC calculation is on securities investment exposures, not trading or even lending, which are less that 10% of the $90 billion in economic capital calculated for the bank. USB has no significant securities operations and is effectively an institutional customer of the larger universal banks.
Despite the relatively low RAROC, USB trades at 2x book value vs about 1.5x for WFC, above 1x for JPM and at or below 1x for BAC and Citi, the two laggards in the large bank group. Some analysts see these low book value multiples for BAC and Citi as an opportunity, but we think these stocks are fairly valued to put it mildly.
Once we get to Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), again the business models are very different. First and foremost, the bank units for GS and MS are relatively small compared to the asset footprint of the broker dealer units, which make up the majority of the total assets at the parent level.
The GS bank unit, for example, has mostly trading risk, with virtually no lending or investment exposures in the EC calculation. Even though it is considered a bank, the vast majority of the risk in the GS business is institutional and is contained in the non-bank broker-dealer operations. The retail component of GS is miniscule, which perhaps explains why Gary Cohn thinks breaking up the big banks is such a great idea. Such a change would have little impact on Goldman but would badly disrupt the small investment bank’s larger competitors like JPM.
MS likewise has most of its assets and business risk in its non-bank units, but its banking operations have a very different profile than the GS banking subsidiaries. GS has most of its bank’s risk in trading. With MS the two primary banks have most of their risk in securities investments for the bank’s depositors, which are mostly the firm’s wealth management customers. Of the $38 billion in EC calculated for MS, less than a billion is for lending or trading.
Both MS and GS are primarily investment houses and both trade at a premium to book value, the two businesses are very different. GS relies far more on trading and investment banking revenue for its profitability, while MS relies more on asset and wealth management. Again, the proposal by Mr. Cohn to separate retail and institutional activities would have little impact on either firm, but would badly disrupt JPM.
The Risk Profile is Very Different At Smaller Banks
Now let’s look at some smaller banks to further contrast with the zombie dance queens. The $18 billion asset Bank of the Ozarks (NASDAQ:OZRK) is reporting earnings this week and will be keenly watched for any evidence of credit stress in its commercial real estate book.
OZRK had a RAROC of almost 29% at year-end 2016 and a ratio of EC to T1RBC of 0.59%. That means that the EC model in the TBS Bank Monitor sees the bank as being more than adequately capitalized to handle its risks, which are about evenly split between lending and securities investments. The bank has zero trading risk, BTW.
So in terms of risk-adjusted returns, OZRK is an order of magnitude more profitable than a large bank like JPM or WFC. It is no surprise that OZRK trade at more that 2x book value and has a large constituency among institutional investors, but also has a pretty volatile stock with a beta of 1.7. Needless to say, the bears like to bet against OZRK on the theory that they are over extended on commercial real estate and related C&I loan exposures. But short sellers beware. OZRK has a very strong credit culture and performed extremely well during and after the 2008 credit crisis.
Let’s take another relatively small name, Signature Bank (NASDAQ:SBNY), which is located in Manhattan. This $40 billion asset New York State chartered institution was organized by a group of bankers who originally came from Republic National Bank.
Signature focuses on C&I lending to small and mid-sized businesses in the US and have some of the strongest credit metrics in their peer group. While defaults did pop above peer at the end of 2016, the bank has historically tracked below peer in terms of credit losses even during the financial crisis.
SBNY had a RAROC of over 11% at year-end 2016, but earned an EC to T1RBC ratio of 2.1, according to the TBS Bank Monitor. While the bank has no trading risk, it does have a large securities investment book, which accounted for more than 90% of the EC risk calculation. Unlike the large banks, however, SBNY is actually sufficiently profitable on a risk adjusted basis to cover its cost of capital. SBNY is a $140 stock that has a beta a little over one and trades at well-over 2x book value.
The point of all of the above is that when you peruse bank earnings starting this week, remember that banks large and small are not all made the same. While they have some common business model attributes, they also serve different markets and customers, even among the largest names. And while the biggest banks are certainly government sponsored entities protected from true competition by federal regulation, small banks like Ozarks and Signature represent the private sector.
Searching For A Too Big To Fail Solution
The bottom line is that the arguments about breaking up the big banks or requiring higher capital levels miss the point. The big banks are problematic because they are too large to generate sustained equity returns compared with their cost of capital or risk-adjusted measures such as RAROC. Requiring big banks to raise or retain more capital would cause them to slowly collapse as equity returns headed into low single digits and share repurchases ended. Small banks, on the other hand, generate great equity returns, but lack the liquidity that big investors demand.
As we argued in American Banker last December:
“Before we can have a rational discussion about how to end the systemic risk posed by the largest banks, we must first understand the root of the problem. First and foremost, the top banks are big because the Federal Reserve and other regulators have over the past several decades allowed and even encouraged a series of mergers between strong banks and weak. By countenancing these mergers and leaving inefficient operations intact, the Fed created enormous firms that are clearly too big to manage and generally do not generate positive risk-adjusted or even nominal returns.”
The answer to the problem of too big to fail is to require banks to become more efficient, not raise more capital, and to allow weak banks to die. We should slowly mandate that the big banks get smaller and also gradually separate dealing activities from the depository over a period of 5-10 years. The good news is that policymakers can address many of the most egregious systemic risks in the U.S. banking system simply by understanding why large banks are big in the first place. The answer starts at the Federal Reserve Board in Washington.
EDITOR'S NOTE
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the new book Ford Men Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.
