Look around the economy right now and there are very few reasons to explain why banks performed so well last quarter, in many cases comfortably exceeding analysts' estimates. When it comes to the nation's biggest banks, in fact, one could argue that there's only one.
As the deluge of bank earnings has come in over the past week, the one area in which JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC), and Citigroup (NYSE:C) all performed well in was trading -- that is, their Wall Street operations.
Banks and trading operations
Since the Dodd-Frank Act was passed six years ago, banks have been forced to scale back their high-risk/high-reward proprietary trading desks pursuant to the so-called Volcker Rule, named after former Federal Reserve Chairman Paul Volcker. This rule largely limits a bank's ability to trade to facilitating the sale and purchase of securities for institutional customers such as hedge funds, university endowments, insurance companies, and sovereign wealth funds, among others.
This is known as market making.
Instead of simply identifying an opportunity to make money by, say, buying a particular type of bond on the open market, banks can only do so if a client wants to offload those securities. This allows banks to facilitate transactions for clients, but ostensibly reduces the size of trading operations and thereby limits the risk of loss at JPMorgan Chase, Bank of America, and Citigroup -- the nation's biggest universal banks.
This is particularly important in a financial system like ours in the United States, where taxpayers shoulder the ultimate risk of loss from imprudent trading operations. We do so by way of the FDIC's Deposit Insurance Fund, which would cover any trading losses that eat into a bank's insured deposits.
But even though the trading operations at these banks have been scaled back, they still contribute to these banks' bottom lines. Indeed, if there was one single reason that JPMorgan Chase, Bank of America, and Citigroup all outperformed expectations last quarter, this was it:
- JPMorgan Chase saw trading revenues climb 33% compared to the year-ago period.
- Citigroup reported a 16% year-over-year increase.
- And Bank of America's trading revenue was up 14%.
This should matter to investors because trading revenue is notoriously volatile. Some quarters, it's way up, as it was last quarter. But other quarters, it's way down, as it was in the third quarter of last year, when trading revenues fell by double digits.
To this end, the dismal trading results from the year-ago quarter also help explain why they were so much higher in the latest quarter on a year-over-year basis.
The point here is that the sustainability of these banks' upbeat performances last quarter is far from certain. If interest rates don't begin rising in earnest or regulatory and compliance costs don't miraculously decline, then it will continue to be difficult for these banks to reach their profitability targets in the quarters ahead.