US universal banks should become smaller and more efficient

US universal banks are too big, so big in fact that they struggle to generate sustained equity returns on a risk adjusted return on capital (RAROC) basis almost regardless of their business model, argues Christopher Whalen, chairman of the consultancy Whalen Global Advisors. In effect, they are not making enough profits over the long-term to meet their cost of capital.

Whalen, who previously headed up research at the Kroll Bond Rating Agency, warns that forcing 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.

He believes that the answer to the 'too-big-to-fail' conundrum is to push banks to become more efficient while allowing weaker ones to disappear.  

"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," he wrote in the Institutional Risk Analyst published by Institutional Risk Analytics.

RoE travails

Bank returns on equity (RoE) collapsed during the 2007-9 financial crisis and stabilised in large part due to central bank actions, such as quantitative easing and favourable lending programmes. However, RoEs never recovered to their pre-crisis levels.

Regulators imposed a raft of measures to increase capital quality to make the financial system safer. Banks also had to beef up compliance operations and invest in new IT systems. To help alleviate these cost pressures banks are turning to technology, though the jury is still out as to whether it can restore average RoEs to double digits.

According to the St Louis branch of the US Federal Reserve, average RoEs for all US banks in Q4, 2016 were 9.07%. From Q1 1992 to Q3, 2007 RoEs were always in double digits, peaking in Q1 2000 at 16.29%. Since then they have not regained double digits.  

“Nominal equity returns in high single digits don’t get it done when your cost of capital is in the teens,” writes Whalen. “Big banks tend to be in low single digits on RAROC, while smaller banks routinely have RAROCs in the teens or much higher.” 

He points out that the US universal banks became so large, partly because US regulators such as Federal Reserve Board, encouraged it. Some regulators believed that big banks were more resilient than smaller ones.

As weaker banks were bought by their stronger rivals, inefficient operations were often kept, and it created organisation that are too big to manage and that mostly struggle to generate positive risk adjusted or even nominal returns.

Glass-Steagall 2.0?

However, Whalen is sceptical about making big banks separate out their institutional and investment banking units from their retail operations following recent reports that the Donald Trump administration is pondering such measures. This should not be done quickly as it is a complex task, he warns (See April issue of GRR: FDIC’s Hoenig proposes a modern Glass-Steagall Act).

"Does anybody in Washington understand how complex and disruptive it would be to impose such a separation?  We doubt it," he wrote. "The much beloved retail business is not particularly profitable, but would require a lot of capital support because of its size."

The second problem Whalen says is that the institutional part of the bank, which hosts a lot of over-the-counter (OTC) derivatives for example, is also very capital hungry on a risk weighted basis.   

“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,” he warns.

Looking at the ratio of economic capital (EC) to Tier 1 risk-based capital (T1RBC) for the banking business, and RAROC, Whalen finds that most small banks have too much capital while the "big zombie banks tend to cheat when it comes to risk and thus have too little capital."

EC defines the amount of capital a bank needs to cover its lending, trading and investing obligations, during a stressed scenario like 2008.

Whalen notes that JPMorgan (JPM) has a particularly poor RAROC of 0.34% and an EC/T1RBC ratio of 2.8% as it harbours a lot of trading risk. By contrast most small banks tend to have an EC/T1RBC ratio lower than one.

The JPMorgan group has around $200bn in T1RBC while the TBS bank monitor model, a tool provided by Total Bank Solutions, calculates that it would need over half a trillion dollars in EC to survive a stressed scenario, mainly due to its large trading exposures and OTC derivatives book. He warns that separating out the retail unit would likely trigger the need to raise considerable capital.  

Wells Fargo Corp (WFC) also generates an EC/T1RBC ratio of 2.8%, but has a better RAROC of 3.73%.

According to Whalen, the biggest risk component of this largely domestically focused group is its securities investments. "Lending is actually less than 20% of the EC number ($384bn) for WFC and trading risk is minuscule. 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," he wrote.

He believes that since regulators allowed certain banks to grow so big, they can also incentivise them to reduce their size and to become more efficient.