* Low rates, more regulation depress profit outlook
* Banks show few fundamental signs of improvement in Q2
* Only choice for big banks may be to slim down
By Jed Horowitz
NEW YORK, July 25 (Reuters) - The summer of 2012 may be remembered as the time when regulation, scandals and a protracted slow-growth economy finally caught up with big American banks.
Ever since the financial crisis, U.S. banks and their investors have held out hopes of a return to the good times, when lending profits steadily rose and commercial and investment banking flourished together. But analysts and investors are now questioning whether things have changed for good.
“My gut says all these megabanks are worth more separately than combined,” said Bill Black, managing partner of Consector Capital, a hedge fund that focuses on bank trading. Smaller, more focused banks could attract investors, satisfy regulators and increase depressed stock prices, he said.
Seven of the 10 biggest U.S. banks beat analysts’ average earnings expectations in the second quarter. But much of that came from cutting costs and dipping into money previously set aside to offset bad loans, rather than from growth in their main businesses, which is what investors want to see.
Revenue from lending, trading and advising corporate clients on mergers is still weak, and low interest rates continue to squeeze profits on loans and other investments. Banks and their already depressed stocks appear headed for a long, grim future.
Nancy Bush, who has been a bank analyst and investor for three decades, said she is ready to throw in the towel on banks of all sizes.
“What’s left at this point, barring a really significant improvement to the economy and a miraculous ramp-up in lending?” Bush asked. “Why invest in these companies? Somebody, give me a reason to believe.”
Toughing out a cyclical economic downturn with more job cuts is not a long-term answer, some banking experts say. Today’s problems derive from structural changes in the financial sector, including increased regulation, and demand a radical restructuring.
“The bottom line is that they have to get smaller so they can manage better,” said Roy Smith, a finance professor at New York University’s Stern School of Business. “They have to give up the idea of being a universal bank holding company that jams together businesses that have nothing to do with each other.”
Morgan Stanley is one financial Goliath that is signaling it gets the message. By the end of 2014 it plans to reduce its risk-weighted fixed-income trading assets by about 30 percent from third-quarter 2011 levels, bank officials said on their second-quarter conference call.
Government data shows loans on U.S. commercial banks’ balance sheets last month grew by 5.3 percent from June 2011, the 10th consecutive month of growth. But low rates and intense competition for the highest-quality borrowers are cutting into the returns earned on mortgage, business and corporate loans, banks’ most robust lending sectors.
Even if banks are making more loans to better borrowers, they are doing so less profitably.
“A protracted period of low interest rates puts a lot of pressure on balance sheets,” said Consector’s Black.
Bankers on their second-quarter calls also raised concerns by warning that the mortgage refinancing boom will likely have run its course by year end.
U.S. Bancorp (USB.N), the seventh-largest U.S. commercial bank, posted about a 17 percent increase in quarterly profit, but cautioned that much of the growth came from mortgage refinancing that is ebbing.
If the economy were turning around, banks might have less to worry about. But Dick Bove, an analyst at Rochdale Securities, said he is feeling squeamish about the economy after reviewing second-quarter earnings calls from 22 bank executives.
“They are seeing very clearly that their clients do not want to hire people or get involved in many capital expenditures,” he said. “If banks from all over the U.S. are saying exactly the same thing, and they did, they are telling you clearly that we are going into a recession.”
One sign of trouble: loan growth is not keeping up with deposit growth.
In March 2010, banks loaned out about 99 percent of money collected from depositors. In March 2012, the figure plunged below 77 percent, the lowest ratio in more than a decade, according to the Federal Deposit Insurance Corp. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ For a graphic on the decline in lending appetite: link.reuters.com/beg59s ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>
Bankers also said on their conference calls that their best clients are increasingly reluctant to invest in their businesses because of uncertainty about the U.S. presidential elections, the end-of-year tax-and-budget “fiscal cliff” battle and ongoing problems with the global economy. [ID:nL2E8IID1O]
For many banks, however, issues go deeper than just a slowing economy. Capital markets businesses, including trading stocks and bonds, are just not as profitable as they used to be. Trading volumes are in a long-term downtrend globally, and regulators are clamping down on banks’ ability to bet their own money.
The big banks also must use more capital to support their riskier trading businesses at a time when the businesses provide sub-par returns. Major commercial banks with investment banking arms, along with standalone investment banks such as Goldman Sachs Group (GS.N), will suffer, analysts said.
“Nine out of the 10 biggest capital-markets banks in the world can’t earn their cost-of-equity capital,” said NYU’s Smith, a former partner at Goldman Sachs. “If you sit around and bet on these guys because they are undervalued, your patience is running out.”
There are some banks, to be sure, that have stuck to their commercial bank knitting and won perennial plaudits - and strong valuations - from investors and analysts. They include Wells Fargo Corp (WFC.N), the fourth largest U.S. bank by assets, and U.S. Bancorp. These banks have strong credit controls, have generally avoided cut-rate pricing to gain market share, and have been gradually adding fee-based, rather than interest-centered, businesses.
Analysts, however, say their top institutional clients are increasingly reluctant to invest in any bank stocks. Last week prominent hedge fund manager Bill Ackman said his firm sold its big position in Citigroup (C.N), despite his general admiration for the bank’s management, because the banking system has become too risky.
JPMorgan Chase & Co’s (JPM.N) almost $6 billion of derivative losses and the Libor interest-rate-fixing scandal in the last few months proved to be the “proverbial straw that broke this camel’s back,” Ackman wrote to his clients at Pershing Square Capital Management. [ID:nL2E8IIH3T]
For months, JPMorgan Chief Executive Jamie Dimon had no idea of the size of the losses brewing inside his bank, signaling to many investors that major banks are too big and too complex to manage, investors said.
“If I don’t think that even insiders have a great handle on what’s going on, I‘m certainly not comfortable about investing my capital there,” said Consector Capital’s Black.
(Reporting By Jed Horowitz; Editing by Edward Tobin and Leslie Adler)
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