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Matthew Indyke and Brian Zen
Matthew Indyke and Brian Zen
Articles (23)  | Author's Website |

Post-Crisis Banks Struggling with Risks

July 19, 2012 | About:

Will banks, big and small, be able to achieve high return on equity again in today’s post-financial crisis environment? That question hangs over all bank investors. Arguably, the banking industry, out of all major industries, got hit the hardest during the economic recession. Since the start of the recession in 2008, banks have traveled a hard road of bad debt, volatile funding markets, and an uncertain economy.

Small banks are having a hard time. According to data provided by David Weidner of the Wall Street Journal, 29 start-up banks in the U.S. have failed and an extra 180 have been sold off to bigger banks. Furthermore, he notes that it puts the U.S. on pace to lose 7% of the national banking population.

And that’s not the worst of it. In 2007, before the financial crisis caught up with the banks, 164 applications for new banks were filed. Since 2008, only 37 new applications have been registered and none have occurred this year. Prospective banking entrepreneurs are, no doubt, getting the message. They recognize their chances of running a profitable bank are small. They recognize the road more likely leads to failure. And most of all, they recognize that banking is a risky business whose profits are being threatened to be taken away by customers and regulators. Here are three reasons why banks are suffering:

  • Bank revenues rely heavily on investments in risky financial instruments that could dramatically change the financial position in as little as one day.
  • As banks are in the business of making loans, if made to customers that lack the means to pay it back, banks lose money quickly and see bank profits shrink faster than they actually grant the loan.
  • Banks are being required to increase capital requirements, which threaten to put a big dent in their returns on equity.
Risky Investments Yielding Volatile Returns

Banks have been taking on excessive risk to make up for a slow economic recovery. The Office of the Comptroller of the Currency (OCC) recently reported that banks were attempting to boost their leverage in order to increase profitability. The OCC added, "Top risks facing national banks include the lingering effects of a weak housing market, revenue challenges related to slow economic growth and market volatility, and the potential that banks may take excessive risks in an effort to improve profitability.”

But banks are only losing more money as they make riskier investments because their high-risk investments, more often than not, are yielding losses. Making matters worse is the low interest rate environment which has banks struggling with other ways to generate consistent revenue. The presence of low interest rates makes banks vulnerable to rate shocks as banks experience decreasing returns on variable-rate investments. The fixed-rate investments are yielding too small returns to to make up for losses incurred during the course of everyday business in the post-economic recession. Small banks, in particular, are increasingly adding to their investment portfolios and increasing the duration of their low-risk investments in an attempt to obtain higher yields. Because of the low interest rate, banks are being forced into a position of taking more risk to improve interest spread.

Look no further than JPMorgan Chase (NYSE:JPM), which recently made headlines after incurring hefty losses on risky trades. Over the past three years, according to Friday's Financial Times, JPMorgan’s chief investment office had built up positions totaling more than $100 billion in the complex, risky bonds at the center of the financial crisis in 2008. CEO Jamie Dimon authorized the department to invest mostly in government-backed securities and to seek profit by speculating on higher-yielding assets such as credit derivatives. And Dimon sometimes suggested investments, such as bets on large economic trends or an asset class. The result was large losses reported as low as $2 billion but found to be as high as $20 billion. Dimon’s conduct and JPMorgan’s business structure have been under investigation after this incident and the bank’s future and Jamie Dimon’s reputation is questionable, at best.

The Loans That Cost Money

A weak economy, persistent high unemployment and a slow foreclosure process are just a few things that have contributed to the recent rise in bad loans throughout the states. "Banks have had a hard time moving this stuff off the books," says Bill Brewer, a partner at bank auditor Crow Horwath LLP. In particular, the overhang of severely delinquent loans and in-process foreclosures on residential mortgages has been a big drag on banks. Regulators were criticized in the most recent crisis forfailing to fully recognize that the buildup in subprime loans and the erosion of credit standards had the set the stage for afinancial meltdown and massive taxpayer bailouts. The more bad loans a bank is making, the more likely it is finding itself in debt and on the road to bankruptcy. Because loans look riskier in the post-recession environment, rejection rates are staying at a high level.

Which banks have rejected the most loan applications? Here are the top three rejection rates, based on a survey conducted by the National Federation of Independent Business:

Bank of America (NYSE:BAC) – 13.5%

JPMorgan Chase – 11.6%

Wells Fargo (NYSE:WFC) – 11.2%

And it should be noted that the next-highest rejection rate after Wells Fargo occurs at 2.9%. It seems smaller banks are more willing to lend now. The top rejection rate of BofA is ironic, given the statements the bank has recently made about its commitment to making these loans and to hiring more small business loan officers. But the reject rate at BofA is likely a result of more customers with questionable credit history applying for loans at big banks. “It’s the health of the banking system and the banks’ ability and willingness to extend credit that’s at the heart of any recovery,” says David Jones, president of consulting firm DMJ Advisors LLC. “If anything helps in getting this recovery going, it’ll be those regional banks.”

Financial industry entrepreneurs, as a result of more loans tied to bad credit, are more likely smelling blood in the water and looking to stay away from banking. Overall, the lending environment still looks dicey and probably always will be, with the most recent optimism survey from NFIB showing more entrepreneurs with a negative outlook on obtaining credit.

Managing Capital on Hand to Cover Unexpected Losses

Bank leaders recognize that more capital is required to guard against losses related to fluctuating interest rates and bad loans. But the critical point of debate centers on what level of capital would be consistent with the bank’s risk appetite and commercial objectives. If banks are required to keep more capital on hand, then it lowers their ROE. But if their level of capital is too low, it can mess up their balance sheet with too little assets to cover too many liabilities. Internally, business unit managers are trying to understand how the amount of capital they are allocated reflects the risk of their business. The challenge is balancing the number of high-risk investments with what the bank wants to retain as capital. For instance, big banks are trimming assets to satisfy stricter capital rules. Shareholders, debt holders and regulators are seeking to size up the amount of capital the bank is targeting, how this compares to the minimum, and how much capital is currently available on the balance sheet.

Bank of America CEO Brian T. Moynihan, 52, has sold more than $50 billion in assets to boost capital and simplify the firm since taking over in 2010. Moynihan said in a Bloomberg Television interview last year that every percentage point of additional capital required by regulators reduces potential bank lending by $18 billion. Bank of America has, at best, seen mixed results since Moynihan took control.

“It’s been clear to banks, big and small, that public policy is not looking favorably upon them,” said Lawrence White, an economics professor at New York University’s Stern School of Business. For now, bigger banks are achieving the high return on equity they once enjoyed and smaller banks are struggling to start off. It is unclear when things might turn around in the banking sector.

Disclosure: Brian Zen owns shares in Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC).

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Matthew Indyke and Brian Zen
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