U.S. banks are embarking on the season of third-quarter earnings reports on an optimistic note. JPMorgan Chase & Co. on October 13 reported $4.4 billion in net income for the period, a jump of 23 percent year over year, fueled by improvements in mortgage volume and credit quality, lower loan-loss reserves and solid gains in fees.
But with overall economic prospects still uncertain, and J.P. Morgan chairman and CEO Jamie Dimon acknowledging that “mortgage credit losses could trend higher,” the big New York bank and other industry giants may not yet have put the after-effects of the 2007-’08 crisis behind them. With one of those after-effects, the scandal over foreclosure procedures, still in its early stages, analyst and investor attention is likely to turn to another key component of bank performance.
That potential concern is noninterest expenses, and particularly their effect on banks’ ability to maintain the recent earnings momentum. J.P. Morgan’s noninterest costs declined 2 percent from the second quarter to the third, to $14.4 billion. That was better than the 7 percent increase since the third quarter of 2009, a rate equal to the rise in headcount, to 236,810.
Seven percent is above inflation, but it’s not excessive in view of J.P. Morgan’s ability boost its bottom line (though the 23 percent year-over-year earnings growth contrasted with an 11 percent decline in total net revenue, to $23.8 billion). Analysts, however, may begin to focus on the trend in the efficiency ratio, which measures the amount of overhead spending necessary to produce a dollar of revenue. The lower the number, the better.
J.P. Morgan Chase describes it as the overhead ratio, and it closely compares with the Federal Deposit Insurance Corp.’s definition of efficiency ratio: “noninterest expenses less amortization of intangible assets as a percent of net interest income and plus noninterest income.” J.P. Morgan’s ratio was 60 in the third quarter; it took 60 cents of overhead to create $1 in revenue. The number has been rising from 51 in the third quarter of 2009, 52 in the fourth quarter and 58 in the first and second quarters of 2010.
J.P. Morgan is a bit high versus the 56.47 for all FDIC-insured banks for the second quarter (the latest number available). According to a Bloomberg article on operating costs, with data compiled for the second quarter, J.P. Morgan’s 58 was four points worse than Citigroup’s 54, but was ahead of Bank of America Corp.’s 59 and Wells Fargo & Co.’s 60. (Citi had reduced its number of employees to 259,000 on June 30 from 371,000 in 2007.)
For banks above $10 billion in assets, the second-quarter efficiency ratio was 53.81, but for all those of just $1 billion and above, it was 71.99 – and had been hovering above 70 for ten consecutive quarters. The 70-percent threshold is alarming to Croton-on-Hudson, New York-based investment banker and frequent industry critic R. Christopher Whelan, co-founder of Institutional Risk Analytics. In an October 6 panel discussion at the American Enterprise Institute in Washington, part of the think tank’s series on “ Living in the Post-Bubble World,” Whelan noted that that bank efficiency ratios were around 70 in periods of “severe operational stress” in the 1980s and 1990s.
“Now it’s in the 70s, and we’re just getting started” on a rising-overhead cycle, Whelan warned.
He believes the biggest banks with sizable mortgage exposure, including Bank of America and Wells Fargo, “will have to restructure” in the face of overwhelming stresses from functions such as repossessions and foreclosures, which are “not what banks were built for.” Next year, he said, “extraordinary instability in the system” will be manifest in falling revenues and rising costs.
In a critique of the Federal Reserve’s interest-rate policies in his Institutional Risk Analyst, Whelan wrote, “Non-commercial demand for dollars is collapsing in much of the global economy, in part because the Fed is transferring something like three quarters of a trillion dollars annually from individual and corporate savers to the Wall Street banks. And even this vast subsidy will be insufficient to prevent the ultimate restructuring of the top three U.S. banks.”
At the AEI, Whelan said he considers government-initiated loan modification programs and forbearance measures by banks to have been just “buying time.” He said he is hopeful that a change in the political climate will bring “truth-telling leadership” and the rest of the necessary restructuring. “The U.S. can do it first and be ahead of the game,” Whelan said.
Jeffrey Kutler is editor-in-chief of Risk Professional magazine, published by the Global Association of Risk Professionals.
