One of the biggest questions facing Bank of America (NYSE:BAC) right now is whether it can earn its cost of capital while continuing to operate a sizable sales and trading unit. To date, the answer has been "no." But on the bank's latest conference call, Chairman and CEO Brian Moynihan argued that the answer is "yes."
Things were different eight years ago when Bank of America bought Merrill Lynch, thereby inheriting the investment bank's Wall Street operations. One of the most significant changes since then has been to the way regulators treat banks with large capital markets businesses -- namely, sales and trading units such as the ones in Bank of America's global markets segment.
Banks with large trading units not only have to hold more capital and liquidity than banks without them, but they're also penalized more heavily in the annual stress test -- which dictates whether banks can increase their dividends and/or share buybacks.
In this year's test, the results of which were released last month, the Federal Reserve presumed that Bank of America would record $20 billion in trading and counterparty losses in a crisis-like economic scenario. That's more than twice as much as Wells Fargo, which has a more modestly sized sales and trading business, though it's meaningfully less than JPMorgan Chase, which has a larger capital markets business.
Two Federal Reserve governors have even gone so far as to suggest that these increasingly onerous regulatory burdens are designed to force banks to think long and hard about staying in the trading business. Bank of America isn't the only universal bank that's presumably in the Fed's crosshairs, but it's the most vulnerable to these insinuations given its lackluster profitability.
"I think it likely that firms are going to have to change in some cases their size, in some cases their business model, and in some cases their organization," Fed governor Daniel Tarullo told The Wall Street Journal in May. And at an industry conference in June, his colleague Jerome Powell added: "I have not reached any conclusion that a particular bank needs to be broken up or anything like that." The point is to "raise capital requirements to the point at which it becomes a question that banks have to ask themselves."
On Bank of America's latest conference call, Moynihan sought to put all of this to rest, saying that trading, and fixed-income trading in particular, "is a good business for us."
It's a business that benefits not only from its core activities, but also by being coupled with our massive global banking business that has leadership positions across the globe. Together, they generate a pretty steady billion dollars or so in quarterly investment banking fees. It's also an important part of our overall global markets platform, the platform that sits atop the No. 1 global research team for the past five years.
Moynihan went on to observe that its global markets segment generated $3.7 billion in sales and trading revenue, excluding accounting adjustments. That was up 12% compared to the prior-year period. It was the best second quarter for trading in the past five years.
It's hard to argue with Moynihan when you look at its global markets segment on a stand-alone basis. The unit's return on average allocated capital last quarter was 12%. That was the lowest among its four operating segments, but still in line with the bank's overall cost of capital, which Dick Bove from Rafferty Capital Markets estimates to be 12.2%.
On top of this, the 12% profitability figure doesn't include any benefit that the bank's global banking segment, which generated a 16% return on average allocated capital in the second quarter, realizes given access to one of Wall Street's leading sales and trading teams. Moynihan has made this point multiple times in the past, arguing that many of Bank of America's corporate clients want a bank that offers a full slate of banking products and services.
But the problem with Moynihan's explanation is that investors can't simply look at the profitability of Bank of America's global markets segment in isolation; what matters more is the profitability of the entire bank holding company. To this end, we know that the bank's trading operations have a negative spillover effect on the parent company's capital and liquidity requirements.
The question, then, isn't whether Bank of America's global market's segment earns its cost of capital. It is instead whether the segment's benefits outweigh its costs to the bank's overarching profitability. It's the second question and not the first that Moynihan needs to address head-on if he wants to put this debate to rest.