Earnings season has begun, and all of the four largest U.S. banks have now reported their results. In this episode of Industry Focus: Financials, host Michael Douglass and Fool contributor Matt Frankel break down the results and look at what's driving profits higher, as well as where there's still room for improvement.

A full transcript follows the video.

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This video was recorded on April 16, 2018.

Michel Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, April 16th. We're talking about big bank earnings. I'm your host, Michael Douglass. I'm joined by Matt Frankel. By the way, listeners, I have to admit something. Our last two episodes were pre-recorded, and that's because Matt was out for a couple of weeks celebrating the birth of his second child, Ian. So, please join me in congratulating Matt on child No. 2 and also on surviving and coming back to the show. Matt, it's particularly great to have you back today!

Matt Frankel: Thank you, I missed you guys!

Douglass: Aw, shucks. So, there have been some interesting developments. Big bank earnings usually kick off earnings season, so that's usually an exciting beginning to earnings season, and there's quite a bit going on here. Let's start with the headline numbers, which generally were pretty strong completely across the board. All of the big four, that's Wells (WFC -0.27%), JPM (JPM 0.39%), Bank of America (BAC -0.38%) and Citigroup (C 1.04%), beat analyst expectations.

Frankel: Yeah. It really seems that since the financial crisis, the banks are into under-promising and over-delivering. This is a trend we see, it's not always across the board, but it's usually a pretty good theme that the banks beat whatever analysts are calling for in terms of both earnings and revenue. In this quarter, it happened to be, all four of them beat on both the top and bottom lines. 

We knew earnings were going to be higher than a year ago, like, JPMorgan's were 44% higher, Bank of America's were 38% higher. But, that was already in the analysts' estimates, and these banks still over delivered, due to a combination of a couple of things. First is solid growth. Most of the banks grew their loan portfolios and their deposit portfolios. The big exception is Wells Fargo, which we'll get to later on. And also because of expense management. Banks are, one, pushing expense reductions since the financial crisis as a way to boost returns and earn acceptable profits in the Dodd-Frank era, and also just because technology is advancing and it's making certain things cheaper for banks. For example, a deposit that you make through a mobile app costs the bank about one-tenth of what it costs if you go in and deposit it through a teller. So, thanks to these two areas, banks are doing pretty well right now.

Douglass: Yeah, and you see that really showing up in a couple of areas. One is expense management, not surprisingly. Longtime listeners have heard us harp on the efficiency ratio all kinds of times. JPMorgan's revenue was up $2.7 billion, expenses were up just $0.8 billion. So, that margin expansion meant that they had a 56% efficiency ratio. Bank of America was at a 60% efficiency ratio after dropping its non-interest expenses down about 1%. And Citigroup saw its efficiency ratio at 58%. And generally speaking, we're really, really thrilled if we see an efficiency ratio under 50%. But under 60% is pretty good. And what you've really seen is these trends playing out positively for the big banks. Plus, one of the important things to note is, that expanse management is not coming at the cost of growth. And that, to your point, Matt, that really highlights what technology and automation and some of these other things that they're really focusing on are driving for them. And JPMorgan saw a core loan growth of 8% and deposit growth of 6%. Bank of America had 3% deposit growth. Those are good numbers to see, especially when there's expense management going on. Of course, all that translates to much better profitability.

Frankel: Right, we're seeing some profitability numbers from the banks that we have not seen in over a decade. JPMorgan was the shining star of this quarter. I know that's one of Michael's favorites as far as the big banks go. JPMorgan put up a 15% return on equity and 1.37% return on assets. This is getting into the realm of an internet-based bank, in terms of profitability. Just to give you some context, that's up from 11% on return on equity and 1.03% on return on assets just a year ago. A lot of this is fueled by tax reform, which we'll talk more about in a minute. But a lot of it is just good old-fashioned expense reduction and growth fueling these profitability numbers. Wells Fargo put up over 12% on return on equity, 1.26% on return on assets. Generally speaking, the industry benchmarks are a 10% return on equity and a 1% return on assets. Bank of America exceeded both of those for the first time since the financial crisis. So, these are really positive signs for bank investors, that things are really truly finally returning to normal.

Douglass: Yes. And a sign, as well, that as interest rates continue to rise, there's going to be long-term margin expansion for these banks which, anyone who's a bank investor, that's a good sign. Although, not, perhaps, as much margin expansion as expected. Citigroup saw their net interest income miss, just slightly. It was $11.17 billion vs. $11.26 billion. Not a huge miss, but a slight one there. Another strong point for banks, wealth management. 

Frankel: Yeah. Wealth management has done well, and there's two things you need to know about the wealth management numbers you're seeing in bank earnings reports. The stock market has been doing great over the past year. If you look at where the stocks you own were a year ago and where they are today, they've probably done pretty well. So, assets under management at a lot of wealth management firms have gone up just because of that, because the assets themselves are worth more. What you really want to pay attention to is what are called inflows, or net flows, is how a lot of the banks will put it. JPMorgan saw record inflows this quarter. That means people are putting money to work in investments rather than in cash. Merrill Edge, Bank of America's platform they acquired from Merrill Lynch several years ago, saw its assets grow by 18%. The stocks that customers own did not grow 18%. A lot of that was new investors coming into the market, people depositing more money in their accounts. So, this is really organic growth. It's really good to see.

Douglass: Yeah, absolutely. With that in mind, we're seeing a lot of good things. Interestingly, most of the big banks fell after reporting earnings. What do you make of that?

Frankel: There are a few reasons they could have fallen. The first one, as you said, the margin expansion wasn't quite where people wanted to see it. Bank of America's was actually flat because they got rid of their international credit card business. Citi's and JPMorgan's had margin expansion, but not as much as a lot of people had expected. So that's one reason. Tax reform, we're starting to get some concrete results, which we'll get to in a little bit, that wasn't quite as good as expected. And as we'll talk about also in a minute, trading revenue isn't where it needs to be just yet, considering how volatile not only the stock market but interest rates have been over this first quarter. So, there are a few reasons why investors could be selling off the banks on these earnings news.

Douglass: Sure. So, heading back to the big banks, let's talk about trading volume. For a little bit of background, last quarter, one of the big stand-out problems for the big banks was that trading volume was weak. And despite the fact volatility has definitely increased, anyone who's invested in the last month has noticed that volatility has increased, trading revenue is still pretty darn weak.

Frankel: To be clear, this was a good problem to have. The reason trading revenue was weak was because the market was just going up and up and up, interest rates had remained pretty low consistently. So, when the stock market is going up and up and up and there's no volatility, there's less of an incentive for people to trade. Same with interest rates. When interest rates are pretty predictable and consistent, there's obviously going to be lower trading volumes. So, it made sense that that was the problem. That was offset by things like increasing wealth management businesses and the such. 

But now, since we've had a pretty volatile first quarter, especially in the context of the past few years, in terms of both the equity markets and fixed income markets, analysts were expecting, especially fixed-income trading, which has been the big problem, to shoot up over the quarter and it just didn't do so as much as expected. In JPMorgan's case, fixed income trading revenue was completely flat year-over-year, whereas analysts were expecting about 3% growth. Bank of America's fixed-income trading revenue missed estimates by about $400 million. Citigroup's fixed-income revenue missed by almost $300 million and was actually down 7% year over year. Now, in all of these cases, equity trading revenue helped make up for it. In Citigroup's case, it was up by 38% year over year thanks to the volatility in the market. But, fixed-income trading was kind of a big letdown this quarter. Analysts just thought it would pick up more than it had because of the nominal interest rates.

Douglass: Yeah, absolutely. This is part of the nature of the big banks, there are trade-offs within the trade-offs. We always talk about how, well, trading will be weak when the market is going up. Well, also within trading, you have your fixed-income vs. your equities, and that's going to be different when you have volatility around interest rates and around stocks. So, there's a lot of moving parts, but that's where that stands. 

OK, we've buried the lede enough, let's talk about tax reform. Big, positive moves for the banks on tax reform, big reductions in their effective tax rates.

Frankel: Yeah. We knew this was going to be a big deal for the banks. For those who aren't too familiar, the corporate tax rate dropped from 35% to 21%. So, we knew this would be a big impact on the banks, and it is. Bank of America pointed out that they're expecting a 9% ongoing benefit from this. To put that into some dollars context, this will save Bank of America approximately $3 billion a year based on their current earnings rate. So, this is a big deal. JPMorgan, for the quarter, posted a little over 18%, so did Wells Fargo, for their effective tax rate. Usually, these are in the high 20s. So, that's consistent with Bank of America's 9% prediction. It could be that investors are just finally getting some concrete numbers, and it's less than the spread between the 35% former tax rate and the 21% current corporate tax rate, so, they could have just been expecting a little bit more, and that's a reason for some possible disappointment.

Douglass: Yeah. It's interesting, because I look at this, and within the framework that I'm not confident that big banks are a good investment long-term, this was a pretty darn good quarter for three of the four of them. So, if investors aren't happy now, I wonder when they will be, because in general, things are looking pretty good for the three of the four. Let's, of course, talk a little bit about the problem child of the bunch, which is Wells Fargo. Not as great of a quarter for them.

Frankel: No. And they had some of the same benefits, they had tax reform working in their favor. But, generally speaking, Wells Fargo is not doing that great right now. A lot of investors originally thought that when they had their big fake accounts scandal over a year and a half ago now, that that was going to be a quick, temporary thing. And I was actually hoping it would be, as well. But since then, a few other scandals have come to light. The bank is uncertain how that's going to affect their bottom line. They just put out a big statement in their earnings report that these results may not be the real results, depending on the outcome of certain legal matters. And on top of that, the Federal Reserve says Wells Fargo can't grow past their asset level at the end of 2017.

So, from an investment thesis perspective, they're not even in the same ballpark as the other ones, for the time being. And you're seeing the public distrust caused by the scandals affecting their numbers. Their revenue actually fell year over year. Their net interest income fell year over year, which is really alarming in a time of rising interest rates. Their net interest margin actually dropped by three basis points. Their deposits went down. That means people are pulling their money out of Wells Fargo. I mean, less than 1%, but still, at a time when everyone else's is going up by 3-5%, this is a big deal. Their loan portfolio dropped by 1%. They're the least efficient out of the big four banks by far with about a 65% efficiency ratio.

Douglass: Which is a big reversal from the past.

Frankel: Oh, yeah. Wells Fargo for, I would say a period of over 10 years now, up until about 2017, was the most efficient, the most profitable of the big four banks. And that's not the case anymore. In most ways, I would say even Bank of America is looking a lot better than Wells Fargo right now, which a few years ago would have been a crazy statement. No one would have believed me for saying that. I wouldn't have believed me for saying that a few years ago. 

And to be fair, they recognize completely that they're still in the early stages of turning the ship around. They know that they have a lot of work to do, and the new management seems pretty focused on doing it, it's just going to take a lot more time than it originally looked like, especially with all the mini scandals that are coming out, and the Fed's penalty, which is pretty unprecedented.

Douglass: Yeah. Definitely a long road to recovery for Wells Fargo. Matt, let's take a step back and look at these stocks from a long-term perspective. We've covered a lot of news and a lot of numbers, and that's all very important, because, of course, when you're thinking about a company, you need to know with some detail what's going on. Do you think any of the big banks is well-equipped to handle the incoming disruption that we've talked about on past episodes? When I look at this group of companies, I'm happy that they're there, because they're excellent barometers for what's going on across financials, but I do question long-term what their road to prosperity looks like.

Frankel: That's true. A few episodes ago, we talked about how the reduced banking regulations over the next coming years that are being proposed wouldn't affect the big banks. So, that actually adds in another dynamic that, it kind of levels the playing field between the big banks and the smaller banks. I mean, big banks have a lot of inherent advantages. Scale is the obvious one. Brand name recognition, you can't ignore that. But, between that and the disruptors we talked about, the lending, especially, is a big thing, with all the peer-to-peer lenders and other ones like Marcus by Goldman Sachs coming onto the market and giving people who need to borrow money a new avenue that they haven't had before. 

To be clear, I'm a Bank of America shareholder, I have been for some time. It's one of my biggest stock positions, and I think they're going to be a good investment long-term. But it's getting tougher to make the case that some of the smaller disruptors and smaller banks are not going to be even better.

Douglass: Yeah, and I think that's definitely a major concern. And by the way, folks, if you are hearing this conversation and you're like, "What was that earlier episode?" That was our April 2nd episode on Five Ways Banks Are Being Disrupted. If you need the transcript or anything like that, just shoot me an email, [email protected], and I'll be happy to send that on to you, or you can just listen to that in your podcast app.

Alright. Folks, that's it for this week's Financials show. Questions, comments, you can always reach us at [email protected]. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!