Banks are not as profitable today as they were before the financial crisis, leaving many investors scratching their heads as to why. The average return on equity across the industry has been below 10% for 35 consecutive quarters, according to data from the FDIC. It was just 9.13% in the 2015 fourth quarter. That, frankly, is not very good.
Many are blaming the Dodd-Frank legislation for these weak profit figures, leading investors to conclude that sub-10% returns are the best that banks can do going forward. I disagree. I think that banks can and will return to historical profitability levels, and that blaming Dodd-Frank overlooks a much more critical -- and temporary -- factor. In my analysis, Dodd-Frank isn't driving the decline in bank profitability; interest rates are. Let me explain.
What has Dodd-Frank done?
To start, we need to understand exactly how Dodd-Frank has changed the game for banks. From there we can assess how significant these changes really are in relation to bottom-line profits today and going forward.
So what has Dodd-Frank actually done? It's forced banks to hold more capital and liquidity on their balance sheets than perhaps ever before. Rules derived from Dodd-Frank are forcing banks away from certain business lines perceived as having more risk, and simultaneously forcing banks to spend more on the infrastructure to provide consumers with simpler, easier-to-understand disclosures. Regulators have more power than ever, holding sway not just through consumer protection, but through capital planning, compensation policies, and more.
Many respected and experienced bank investors think the costs to comply are far too high, and that Dodd-Frank is to blame for the profitability problems across the industry. Tom Brown, an outspoken fund manager specializing in bank stocks, has called the industry "inherently less profitable" in the "post Dodd-Frank system." He says that "while Dodd-Frank has strengthened the banking industry by insisting on stronger capital and liquidity, it has weakened it by sapping banks' inherent ability to make money."
Dodd-Frank's influence can be seen in evolving bank strategy as well, most notably at investment banks like Goldman Sachs (GS 0.47%). Goldman became a bank holding company during the crisis to expand its ability to tap into government funding resources, and today is expanding into retail banking, buying GE Capital's consumer loan book and opening GSBank.com, an online retail bank. The reason is that its traditional business lines -- trading, investment banking, market making, and the like -- are the exact business lines targeted by Dodd-Frank's toughest rules.
Analyst Dick Bove of Rafferty Capital Markets has called the last 10 years Goldman's "Lost Decade," based on the bank's failure to change quickly enough to the new environment created by Dodd-Frank. He says that "what management did not fathom was the better approach would have been a transformational change so that capital could be used in a more productive fashion than supporting businesses that were declining on a secular basis." Out with proprietary trading, and in with deposit accounts for consumers.
Even banks without any material reliance on investment banking haven't escaped Dodd-Frank's reach. M&T Bank (MTB 2.18%), a $125 billion regional bank, is a great example. Since 2013, M&T has spent $178 million on consulting firms alone as it worked to restructure its compliance function and bring it up to Dodd-Frank standards. Its risk management group's headcount has expanded from 128 to 807 over the same time. The bank's total compliance costs in 2014 and 2015 were nearly $900 million combined. For context, the bank's annual net income in 2015 was $1.08 billion.
Correlation does not equal causation
The financial costs of Dodd-Frank compliance are real, and they are clearly huge. No one is debating that point. However, if the expenses related to Dodd-Frank compliance were so dire, then we'd expect to see bank income statements overwhelmed with new, higher operating expenses. And yet, when you examine specific banks and the industry by and large, the opposite turns out to be true.
Across the industry, efficiency ratios average just under 60%, only a hair above the 58%-59% averages seen pre-crisis. A bank's efficiency ratio measures the expenses required to produce each dollar of revenue. A lower efficiency ratio is considered more efficient.
How is that possible? Credit goes to bank management teams doing an excellent job cutting costs and streamlining their operations. The chart below shows the average ratio of noninterest expenses to quarterly average assets for all U.S. banks. The trend is clear: Banks are in fact reducing their operating expenses, and they're doing so in the face of rising regulatory costs.
Data source: Fourth-quarter 2015 FDIC Quarterly Banking Profile.
Bank of America (BAC 0.80%) is a great example of this dynamic in action. Last year the bank completed a cost-cutting plan, called Project New BAC, that cut more than $8 billion in annual operating expenses. Even Goldman Sachs has been very effective reducing its cost base, even if it's been slow to implement the "transformational change" recommended by Dick Bove.
GS Total Operating Expenses (Annual). Data by YCharts.
If it's not regulatory expenses, what is driving bank profitability lower?
At this point, we know that bank profitability is lower than historical norms. We also know that there's been a major regulatory overhaul that has increased the compliance costs across the board. However, we also see that bank expense management is actually improving over the same time that regulatory costs have increased. That leaves us with the other major change since the financial crisis, and the true driver of lower bank profitability: low interest rates.
According to data from the FDIC, the average yield on earning assets across the banking industry was 3.48% in the 2015 fourth quarter, 49% lower than at the pre-crisis peak in the second quarter of 2007. It's down even farther from the high rates seen around the turn of the century.
Data source: Fourth-quarter 2015 FDIC Quarterly Banking Profile.
To put the significance of low interest rates further into context, let's do some quick back-of-the-envelope math to compare Bank of America's 2016 first quarter to its numbers from 10 years ago, when rates were at more normal levels.
In the first quarter of 2006, Bank of America generated $8.8 billion in net interest income, the difference between its interest revenue and interest expenses. That number represented 0.62% of the bank's total assets at the time. Ten years later, Bank of America's first-quarter (2016) net interest income was 0.42% of the bank's total assets today. If, all else being equal, the yield environment in 2016 was the same as in 2006, the extra 20 basis points of net interest income would have increased profits before taxes by $4.4 billion. That would be a jump of 263%.
There are, of course, multiple other considerations to take into account beyond this admittedly simple calculation. However, in no uncertain terms it is clear that today's low interest rates are a much more significant factor in bank profits than Dodd-Frank. When the prices a business charges on its primary product drop by nearly 50%, it shouldn't come as a surprise that profits are also down.
Why this analysis matters for investors
Understanding the dynamic here is critical for investors. If today's low rates are the primary driver of reduced bank profitability, then today's lower profits should be considered temporary. When rates rise, bank profits will return to their historical levels as well.
However, if investors believe that Dodd-Frank and other legislated burdens are holding back profits, then that situation could be far more permanent and justify far lower bank stock valuations today and in the future.
In my view, Dodd-Frank is not the most significant factor driving lower profitability in the banking industry. Yes, the new regulatory regime has increased costs, and it demands banks to do business differently than was the norm before the financial crisis. But banks have done an admirable job managing through those changes, cutting costs where appropriate, and evolving to succeed in today's environment.
The bigger issue impacting the bottom lines of U.S. banks are low interest rates. Once the interest rate environment returns to historically normal levels, I think bank profitability will also rise to prior levels. And, thanks to Dodd-Frank, when that day comes, these banks will be better capitalized, have more liquidity, and be better prepared for any future crises that arise. For long-term investors, that's a win-win scenario.
