Our banking system needs more capital now

NEW YORK (MarketWatch) — During the 2008 banking crisis, in an effort to refocus investors away from what they saw as the one-time “event” of extremely high mortgage charge-offs, many of our largest financial institutions promoted a new metric — pre-tax, pre-provision profit (“PTPP”), calculated as revenue less expenses, excluding loan loss provisions.

By emphasizing this metric, bank executives were all but begging investors to look past the credit crunch and to appreciate the profit potential that their franchises would have when the dust finally settled.

In fact, in March 2009, on the heels of Federal Reserve Chairman Ben Bernanke’s green shoots interview on “60 Minutes,” then Bank of America
 Chairman Ken Lewis went so far as to offer a specific forecast, noting in a speech in Boston that his bank would “generate more than $100 billion in revenue and close to $50 billion in pre-tax, pre-provision earnings” for 2009.

Well here we are almost two years later and nobody is talking about PTPP anymore. Instead, the only thing bank chief executives are emphasizing is their declining provision expenses and the contribution that it’s making to the bottom line.

PTPP is a key metric for financial institutions, as it measures a bank’s “lung capacity” and the ability to build loan loss reserves out of current period earnings.

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In looking at Bank of America’s earnings on Friday, I was candidly struck by the bank’s surprisingly weak PTPP, just $28.3 billion for the year — well below the $53 billion that actually topped Ken Lewis’s forecast in 2009. And what was even more surprising to me was that BofA’s 2010 PTPP was even with the bank reporting that the average cost on its over $1.0 trillion book of deposits was just 25 basis points (0.25%), and its $940 billion loan book had a yield of almost 4.5%. In the world of banking, it doesn’t get much better than that.

Now I can already hear the B of A investor relations folks calling to say that my figure is too low and that I should instead take out 2010’s one time charges and use $40 billion instead (like they did in their earnings presentation). Unfortunately, and with all due respect to the folks at B of A, until there is a recovery in housing, nothing in my book is one-time. Further all those “non-cash” goodwill charges that the bank wants everyone to exclude are based on forward-looking views of revenue (which the write-downs suggest will be significantly lower than they thought) and some of the things they want to include as ordinary (like the write up in their deferred tax asset) I view as completely spurious in the first place.

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So where I come from, PTPP — revenue less expenses — was $28.3 billion or just 1.25% of assets. And even if I am generous and use its number, the figure is still only 1.8% — not a lot of wiggle room for potentially higher credit losses.

Now in fairness to BofA, it was hardly alone in reporting lower PTPP for 2010. Wells Fargo’s
 PTPP dropped 12% year-on-year, while Citigroup Inc.’s
fell 18%.

Broadly speaking for our largest banks, the key variables of PTPP — net interest income, non-interest revenue and expenses — all deteriorated this past year. Despite record low deposit costs, most bank net interest margins actually shrank. Trading results were uneven (particularly compared to 2009 when every mark-to-market asset seemed to do nothing but go up) and non-interest income was under pressure from any number of new banking regulations. At the same time, expenses rose as compensation, loan servicing costs and litigation all increased — some substantially.

Part of me can’t help but wonder whether this is the new normal for the financial services industry. But the net result is that without the improvements in credit costs, bank results for 2010 would have followed PTPP lower.

I highlight all of this because over the next several months the banking regulators are going to re-“stress test” our largest banks to determine whether they should be permitted to raise their dividends. And at least to these eyes, the declining trend in PTPP raises a serious red flag. Read Minyanville’s “Dividends: Banks Poised to Deliver.”

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With lower lung capacity (PTPP), loan loss reserves and tangible common equity levels become even more important to systemic safety. And with reserves now declining due to improving delinquency levels, that really leaves just tangible common. (Which I would interject here is what the regulators should have been focusing on exclusively ever since SEC Chairman Arthur Levitt mandated pro-cyclical as opposed to much more useful counter-cyclical loan loss reserve accounting for the banking industry.)

Now I am sure that the banks would counter that both the quality and quantity of their capital base is higher today than ever. And while I agree, I would note that so too are the market’s expectations for minimum capital levels (now that investors too have learned the hard way about the effectiveness (or rather lack thereof) of counter-cyclical loan loss reserves).

And unlike others, I believe that what the market expects is far more important than what the regulators may mandate. Yes, tangible common for most banks has more than doubled from the meager 2% to 3% level before the crisis, but 6% tangible common is the new market floor, and on that basis, tangible capital cushions are not as plush as equity investors (and more importantly the regulators who tend to look only at risk-weighted capital ratios) may think. And there is nothing that would prevent the market (particularly the non-deposit debt market) from choosing an 8% or even 10% threshold in the future, especially if the “bail-in” of non-deposit lenders in Europe expands as I anticipate. Read Minyanville’s “European Banks Running Out of Options to Raise Liquidity.”

And then there is the current state of the Deposit Insurance Fund — which as of the end of the third quarter had a deficit of $8 billion backing more than $5.4 trillion in insured bank deposits. It seems to me that from a systemic risk standpoint, if anyone should be getting the benefit of excess capital/earnings in the banking sector it should first be the FDIC.

And as a final factor as to why regulators should want banks to hold more capital let me throw in the inability of future monetary policy to boost bank earnings like it did during 2008. With deposits already close to free, there is little the Fed can do today to lower bank funding costs from here. And the market’s latest reaction to the second round of quantitative easing (QE II) at least puts into question how effective the Federal Reserve may be in the near future in bringing down the long end of the curve (in an effort to generate mark-to-market gains) — at least not without dramatically increasing the Fed’s balance sheet.

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To these eyes the 2008 impact of monetary policy on bank earnings was unfortunately a one-hit wonder. And today, it is very hard for me to see how net interest margins can in any way expand to help cover higher loan losses should they occur right here and right now. And I’d offer the same thing is true with regards to non-interest income elements as well. During 2008, the banks dramatically raised deposit account and service fees and front ran Dodd-Frank, two options that clearly no longer exist. That leaves cutting operating expenses further, which while possible, all too often necessitates “one-time charges” which would only exacerbate earnings issues and eat into capital.

As I see it, banks have very limited flexibility to increase pre-tax pre-provision income (PTPP) like they did two years ago to help offset higher credit losses. And with the pro-cyclicality of reserves already kicking in, that leaves tangible capital as the only defense against a currently defenseless FDIC.

Yes with time, all of this could change. But the question the banking regulators must answer is whether the banks should be allowed to return capital to shareholders now.

I know Washington is trying to be more business-friendly and I appreciate that. But if our policy-maker’s goal really is long-term global competitiveness, then we must start by building a solid, stand-alone foundation at our largest financial institutions. Read Minyanville’s “Washington and Your Money.”

And from what I can see today, that means more tangible common equity now. A lot more.

View more information: https://www.marketwatch.com/story/the-banking-system-needs-more-capital-now-2011-01-26

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