For Most Big Banks, Pre-Crisis Returns are a Thing of the Past

S&P Global Market Intelligence
Written By: Joe Mantone and Chris Vanderpool
S&P Global Market Intelligence
Written By: Joe Mantone and Chris Vanderpool

Despite a boost from tax reform, returns at most of the nation's largest banks remain well below pre-crisis levels.

The largest U.S. banks have reported steadily improving returns since the credit crisis, and a lower corporate tax rate helped push profitability higher in the first quarter. Still, returns at all but one of the big banks have lagged pre-crisis levels, largely because of capital and liquidity rules passed with the Dodd-Frank Act. The considerable increase in capital has suppressed returns on equity, while heightened liquidity requirements have squeezed margins.

JPMorgan Chase & Co. is the outlier among its peers with a first-quarter return on average equity of 13.7% that stands above its 13.0% return in 2006. In its first-quarter earnings release, JPMorgan said the tax cut helped lower income tax expense by about $240 million, despite a $2.0 billion increase in pretax income.

The other bulge-bracket banks benefited from lower taxes but did not reach pre-crisis returns.

Bank of America Corp. reported that its tax rate benefited by nine percentage points, while Citigroup Inc. reported a first-quarter effective tax rate of 24%, down from 31% in the year-ago quarter. Still, BofA's first-quarter return on average equity of 10.4% was far below the 16.2% it reported for full-year 2006, and Citigroup's first-quarter return on average equity of 9.2% was far below the 18.9% it reported for full year 2006.

For Goldman Sachs Group Inc., reaching pre-crisis returns has been a challenge thanks in part to Dodd-Frank's Volcker rule, which generally prohibits insured depository institutions and affiliates from proprietary trading — historically a key part of Goldman's business. Goldman's first-quarter return on average equity of 13.6% is less than half of the more than 30% return on average equity the company produced in each of fiscal years 2006 and 2007.

Before the crisis, Goldman Sachs "excelled at" using leverage as a proprietary fixed income, currencies and commodities trading firm to drive revenues and profitability, RBC Capital Markets analyst Gerard Cassidy said in a March report.

But regulations have "greatly curtailed" that practice, making the "old traditional 'Goldman Model' less profitable," Cassidy said.

The banks have also seen their returns come down because they have been forced to hold more liquid assets, which tend to have lower yields that reduce security portfolio income. The aim of provisions such as the liquidity coverage ratio is for banks to hold assets that they can quickly turn into cash to cover short-term obligations.

Regulators have taken such measures because illiquid assets held by financial institutions contributed to the financial crisis. A lack of liquidity led to the collapse of Bear Stearns Cos. LLC, whose sale to JPMorgan hits the 10-year mark on May 30.

But efforts to loosen some liquidity restrictions are being made in Washington. In March, the Senate passed the Economic Growth, Regulatory Relief, and Consumer Protection Act, which allows investment-grade municipal bonds to qualify as high-quality liquid assets when determining banks' liquidity coverage ratio.

There is also a push to reduce some of the capital requirements large banks face. In April, regulators proposed re-calculating the enhanced supplementary leverage ratio that applies to U.S.-based global systemically important bank holding companies.

Holding additional capital is the biggest factor weighing down returns, Vining Sparks analyst Marty Mosby said in an interview.

Increased capital requirements are meant to help banks survive a downturn. But forcing banks to hold too much capital can lead to more risk-taking, Mosby said. Overly stringent capital requirements could entice banks to consider higher-risk businesses in an effort to boost returns, the analyst said.

Banks have yet to seek out too much risk because they have benefited from the post-crisis economic recovery, Mosby said. Institutions have seen credit costs go down, and they could see another tailwind if higher interest rates push up their net interest margins, he said.

Technological improvements that lower expenses can also improve ROAE. Better risk management systems that reduce spending on staffing can help banks more efficiently deal with regulations that have been adding to the cost structure.

But even if returns never reach pre-crisis levels, the regulatory requirements are good for bank valuations, said Nellie Liang, a senior fellow with the Brookings Institution. The rules make the financial system safer, and that adds value, Liang said.

"It has reduced the probability of default," Liang said in an interview. "It has also taken out the tail risk to the economy."