The "big four" U.S. banks -- JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC), and Citigroup (NYSE:C) -- have all reported their second-quarter earnings.

In this episode of Industry Focus: Financials, host Michael Douglass and contributor Matt Frankel discuss the winners and losers, as well as some sector trends investors should be aware of.

A full transcript follows the video.

This video was recorded on July 16, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, July 16th, Financials, and we are covering big bank earnings, the Big Four -- that is Bank of America, Wells Fargo, JPMorgan, and Citigroup. They have all reported earnings, and we are here to talk through each company and give some summation to the kick-off of traditional earnings season.

Matt, it's great to have you back on the show. Let's start by talking about, arguably, the loser of the bunch. Folks who have been listening to Industry Focus for a while know that's going to be Wells Fargo.

Matt Frankel:

Yeah. This shouldn't come as too much of a surprise to anybody. First of all, Wells Fargo is not allowed to grow right now. They have a big Federal Reserve penalty hanging over them, and it's indefinite in time frame, that says they're not allowed to get any bigger than how big their assets were at the end of 2017. While some of the other banks saw really impressive loan growth, deposit growth, which we'll get to in a minute, we didn't see any of that with Wells Fargo, understandably so. In fact, they're scaling back a little bit to make sure they don't violate the Federal Reserve's penalty and grow. Deposits were down 2% from last year. Loans were down 1%.

This is really troubling to investors, because this is arguably the best time for bank growth in the past two decades. Going a little deeper, Wells Fargo historically has been the most profitable of the Big Four banks. Now, they're No. 3 in terms of return on assets and return on equity. Efficiency, they are the absolute worst with a 65% efficiency ratio. That means they spent $0.65 to generate every dollar of revenue. None of the other three got over 60% in that category.


Let's unpack that a little bit. A reminder for folks -- the efficiency ratio is essentially, you want a lower number. Generally speaking, you want under 60% where possible, but always lower. So, something at 65%, particularly Wells Fargo, which has historically been so good, is a very bad sign.

Also, let's talk about the elephant in the room here for a minute: tax reform. Tax reform has been a big benefit to the big banks. We'll talk more about that with each of them. With Wells Fargo, return on equity and return on assets got worse year over year. That's an incredibly bad sign, given that tax reform freed up all kinds of extra cash that they would have otherwise had to pay up to the government.


To be fair, they had about a $500 million charge that reduced earnings in the second quarter, but it wasn't nearly enough to depress profitability that much.

The other thing with Wells Fargo, there is some good news. It's mainly because their price is so low. First of all, they finally saw some interest margin expansion. They've been lagging the other three since interest rates started to rise. Everyone else's profit margins started to rise a little bit along with it. We finally started seeing that with Wells Fargo this quarter.

The other thing is, because their share price has underperformed the banking sector so much, it's actually a really good deal when it comes to buying back shares. Wells Fargo just got approved from the Federal Reserve for a massive buyback over the next year. They're actually set to buy back about 9% of their outstanding shares at the end of the year. Even if they're not allowed to grow, 9% is actually a pretty decent return for a big bank to give back to investors in one year.


Yeah. Not surprisingly, Wells Fargo is continuing to struggle. We have covered, fairly exhaustively, most of the brand and operational issues at this massive bank over the past couple of years. I think the key question to investors moving forward, thinking about not this year or this quarter but next year, two years from now, ten years from now, is whether right now represents a trough, at which point, the stock is a great buy; or if this represents a new normal because they've cut out of some of that aggressive cross-selling culture because it led to all of that cheating that got them in so much trouble in the first place.

For me, that's very much an open question. That's why I'm very firmly on the sidelines with Wells Fargo and intend to remain that way. That may mean that I miss out, personally, on a great turnaround story one day. For me, I'm OK with that, because I think there's so much execution risk that I would rather deploy my money elsewhere.


I think there's a lot of long-term potential in the banking industry elsewhere that doesn't involve the same kind of wait-and-see mentality.


Turning to our second bank, Citigroup. A mixed bag of good and not so great news, but certainly better than Wells Fargo. They reported 27% year over year earnings growth and 2% revenue growth. Of course, a lot of that earnings growth can be attributed to tax reform, but there are other signs that the business is moving in the right direction.


Right. They're not that bad, in terms of how Wells Fargo was. They're growing in a lot of the ways we like to see. Specifically, loans and deposits were both up by 4% year over year. Citigroup is actually running a very efficient operation, even compared to some of these other Big Four banks. Their efficiency ratio is 58%. You'll recall, Wells Fargo's was 65. Their interest margin is improving nicely. They actually had the best interest margin improvement of the Big Four.

But, on the other hand, they're still not as profitable as they need to be. Citigroup still has a lot of legacy assets. They have by far the most international exposure of the Big Four banks. And their profitability is not where it needs to be. We mentioned return on assets and return on equity briefly with Wells Fargo. You generally want to see over a 10% return on equity and a 1% return on assets. In Citi's case, they're still not there. They're at 9.2% on return on equity, 0.94% on return on assets, and that's after tax reform. We would have expected tax reform to catapult these banks to the profitability levels that they needed to be at, but we really haven't seen that with Citi.

Also, in terms of trading revenue, Wells Fargo is clearly a commercial bank, they don't really deal with investing baking activities, but Citigroup does. Trading has been a big issue for the investment banks over the past couple of years, mainly because market volatility has been so low, trading revenues have been bad. Market volatility has picked up in 2018, so you would expect trading revenue to pick up along with it. For Citigroup, it was a big disappointment on trading revenue. While some of the other investment banks that we know about so far have done really well, Citigroup's trading revenue missed terribly, especially in terms of equities.


Yeah. Like I said, kind of a mixed bag. One of the interesting things for me is this idea of these industry benchmarks. The industry benchmarks assumed, among other things, a tax format that was fundamentally different from the way things work now. The fact is that, in the past, we've expected ROEs of 10% or ROAs of 1%. Long-term, we would expect those benchmarks to move up a little bit if the current bank and tax reform takes hold and remains in place. For Citi to not even be achieving the old benchmark, before all these additional things came in, is really not great news.

Although, I will say, an efficiency ratio of 58% is a welcome change. Citigroup has historically been cheap, and usually for a reason, which is that they've really struggled to get those returns, get that efficiency ratio that the other Big Four banks usually had a little bit better locked down. It's good to see that efficiency, at least, is closer to where it needs to be, even if ROE and ROA are still pretty far off.


Just to piggyback on that, Michael mentioned how Citigroup has been really cheap. They are by far, by far, the cheapest bank, in terms of price to earnings, price to book, price to tangible book, and by a big margin. While they're not as profitable as we'd like them to be, you get what you pay for. If you think Citigroup is going to eventually turn the ship around and be as profitable as the rest of the banks, you're getting a really good long-term bargain at the current levels.


Right. Of course, therein lies the fundamental question.

Alright, let's turn to bank No. 3 of the Big Four: JPMorgan, which had, frankly, pretty good numbers, generally speaking. 26% year over year earnings growth -- again, in large part due to tax reform. If I sound like a broken record, it's probably going to happen again with Bank of America. 6% revenue growth year over year. Frankly, ROE, 14%, which is very favorable compared to Citigroup's 9%; and, a 56% efficiency ratio. Really good to see those numbers all trending in the right direction.


JPMorgan had a bunch of best-in-breed statistics in their earnings report. Just to name a few, I mentioned trading revenue, how it was such a disappointment with Citigroup. It was the opposite with JPMorgan. Their trading revenue jumped by about 13% when they were expecting it to be flat year over year. So, this was a big surprise, as well as being a great achievement. And it was spread out pretty evenly among fixed income trading and equities trading. In both areas of the market we're looking at in trading, they did very well. They actually wound up with the No. 1 market share in global investment banking fees. Considering who they're up against, that's pretty impressive.


Yeah. I'll note as well, one of the things that I tend to look at with any sector is when you have two competitors that have comparable business areas. For example, Citigroup trading, JPMorgan trading. When one of them performs really well and one of them performs really badly, that tells you it's not just a secular trend, it's actually an issue of how they're executing. This is a really good sign for JPMorgan, and not a great sign for Citigroup, that in the same environment, Citigroup struggled, and JPMorgan prospered. That tells you a lot about the quality of management and what they're doing with that particular part of their business.


Yeah. The only reason I wouldn't call JPMorgan the best of the best in terms of bank earnings so far is because they had a couple of negative items. First, and this is not too significant, the had a $330 million charge related to their credit card business. If you're not following the credit card markets, JPMorgan Chase is involved in a big rewards battle with every other credit card issuer where they're seeing who can offer users the biggest sign-up bonus, rewards points. Related to their credit card rewards, their customers are actually taking rewards even more than they thought they would, so there was a pretty big charge that was unexpected.

More significantly, JPMorgan's interest margin actually contracted from the first quarter. You would expect the opposite in a rising rate environment. Generally, a good portion of bank deposits are non-interest-bearing. The rest, interest rates paid on deposits tend to rise slower than market interest rates are going up, so you tend to see margin expansion in rising rate environments. In at least this quarter, in JPMorgan's case, we're really not seeing that.


That's a troubling sign. To be fair, it was essentially flat. We're talking a 0.02% decline in interest margin. But, the fact of the matter is, as the Fed keeps increasing rates, the whole reason banks have been on a run is threefold: deregulation, tax reform, and an expectation that as the Fed raises rates, banking will get more profitable. The fact that it isn't, in this case, for JPMorgan specifically regarding interest rates, is a concern. It's also a way in which it stands out from the other banks, which saw improved net interest margins -- again, not substantially, but they did see improvement. To me, that creates some questions.

Again, one quarter or another doesn't necessarily tell us a lot. Things happen with the timing of various ways of doing things. That's really going to be a question for JPMorgan over the next couple of quarters. It's something I will be keeping a very close eye on, because I want to make sure they're executing well in a rising rate environment. Frankly, that's when they should be executing well.


Yeah, definitely. JPMorgan is pretty much firing on all cylinders these days. We're being kind of nitpicky with the interest margin and credit card stuff. There's really not that much going wrong with JPMorgan Chase at all.


Yeah. Overall, a strong earnings showing, just some questions that we need to consider the next time they report earnings. We want to make sure that those trends are reversing themselves.

Finally, Bank of America. Wow, 43% year over year growth in earnings, 3% revenue growth. Merrill Edge brokerage assets grew 20% year over year. Trading revenue up 7%. All across the board, a very good quarter for Bank of America.


Yeah. I would call Bank of America the clear winner of earnings season so far. In complete disclosure, I'm a shareholder. I've been following Bank of America for a very long time. Since the financial crisis, their turnaround has been phenomenal. Looking at some of these numbers -- they aced the trading revenue. Trading revenue is up 7%. Not quite as great as JPMorgan, but it's in the direction we wanted to see, it was exactly what we thought it would be. Return on equity, return on assets, are both well over those 10% and 1% benchmarks. If you followed Bank of America in the few years after the financial crisis, that would have seemed crazy to predict.

So, Bank of America is really doing well. They've really emphasized expense reduction, especially through technology. Bank of America, in my opinion, is the technological leader of the Big Four, in terms of how much they've invested successfully in building out their mobile platforms, their online platforms, the functionality of customers being able to make appointments with bankers through their phones or computers. They're really almost eliminating the need to go to a branch at this point.

That's really resulted in high efficiency for them. Their efficiency ratio is 59% this quarter. That's the best we've seen from Bank of America in about a decade. So, this was a very, very good quarter. More important than just this quarter, it's really a continued trend in the right direction that we're seeing that's most promising.


I'll note here, a 10.8% ROE and about a 1.2% ROA, those are solid numbers. But for me, within that historical context, that this is much better numbers than they've been reporting in the past, is a very good sign that the expense discipline and the thoughtful work that Bank of America has done in terms of retooling and trying to get smarter and better and leaner and more profitable, at least so far, appears to be paying off. Of course, the big question will be, just what does their credit quality look like when the cycle turns?

Let's step back to general, broad summary. When thinking about this quarter -- we just have the Big Four so far -- we're definitely seeing brokerage and wealth management assets increasing, generally speaking. There are some stand-outs. Wells Fargo's wealth management revenue is down, actually. Those assets are increasing largely due to inflows and stock returns. It's been a great market, and a lot of people are getting more excited about investing.

Of course, the question will be, on the flip side, when the stock market hits the skids -- which inevitably, it will, at some point -- what happens for those business units, and just how sticky are those relationships? That'll be an open question.


Yeah, definitely. Especially in some of these cases, they've been building up their platform for basic retail investors, like Merrill Edge. Those are generally the first to pull their money out when things go bad. We'll see, like Michael said, how sticky that is when things take a turn in the other direction.

The number you want to keep an eye on is inflows or outflows, in the bad case. Don't pay too much attention to, say, if you hear that such-and-such bank grew their assets under management by $20 billion. You want to pay attention to whether there were net inflows or net outflows in that money. That excludes market performance and tells you how many people were putting money in that could help the bank on more of a long-term, sustainable basis.


To step back to the regulatory environment for a moment, tax reform boosted earnings, boosted return on equity and return on assets pretty much across the board, with Wells Fargo being the stand-out that really struggled vs. everybody else. Not surprisingly, we see an environment that's much more positive for banks than it was, say, a year ago. Relatedly, interest margin generally expanding because the Fed is generally raising rates. This definitely a time in the sun for the big banks. Generally speaking, they should be having a pretty good few quarters, and hopefully years, assuming that the economic recovery continues to hold.


That's what I was talking about with Wells Fargo. This penalty where they're not allowed to grow couldn't possibly have come at a worse time. If they had been not allowed to grow in, say, 2009, it wouldn't have been that big of a deal. But this is a great growth environment for banks. To take away that growth engine is really disheartening as an investor.


Yeah, absolutely. We've talked a little bit about expense management. I've harped on this a few times, this idea of the shift toward digital, trying to find ways to run leaner and leaner operations, reducing branch counts, but just to give you a sense of things --76% of Bank of America's deposits are now digital. Mobile and ATM, that's how they get those deposits. 24% are at the actual bank at this point. That's about a 10% shift in that direction in about a year.

Really, we can expect that trend, which is visible across all the big banks, and I assume all of banking, to intensify, particularly as things like Capital One Cafes really highlight people's ability to do more and more of their banking online. It's more convenient for them, of course, they don't have to leave the house; and it's also more profitable for the banks, because then they don't have to have has many expensive banking centers. So, that can help them manage expenses.

Capital One Cafes are really designed to help facilitate that and educate people about that. That's a really interesting opportunity to help brand that as the big banks try to push into a more digital world and control those expenses.


Michael and I disagree on how quickly this going to happen, but it's a clear trend. Here's the takeaway: banks don't want to run branches. Branches are expensive. You not only have to build or rent a building, you have to build out the inside, you have to pay for staff, you have to pay benefits to those staff, you have to buy all the equipment and furniture. Every time someone makes a deposit in person, they have to hand them a receipt, they put it in an envelope -- those all cost money.

Mobile deposits cost roughly one-tenth of what an in-person deposit does. The same goes for an ATM deposit. It's a huge cost difference for banks to be able to shift their business away from physical branches. Even ATMs, like I said, are infinitely cheaper than having an actual branch. This is definitely a trend. I think it'll take a long time, probably the rest of my lifetime, before bank branches become really antiquated. But it's definitely heading in that direction.


For sure. My guess would be more like 15 to 20 years, but we'll see. That'll certainly be something that I think Matt and I will keep in touch on, just to get a feel for how things go. But, the question with all of this, the banks are generally firing on all cylinders, will be, what happens when the cycle turns? When the market declines, wealth management assets probably will, too, just because the amount of money that they have -- if they have a fund that's worth $X, and then you take 20% off the value of that fund because the stock market declines by 20%, then assets under management will decline by 20%.

Of course, there are inflows and outflows to also consider. If there's a recession, credit quality will fall off, too. People tend to pay their debts when the economy is doing well, and unemployment is low. It's a different ballgame if what has been a long and substantial economic recovery and a long and substantial bull market really turn.

That's really where we're going to get the sense of who really made the smart loans and who really trimmed the right expenses -- when things get tougher. In the meantime, banks will probably enjoy their time in the sun, and we'll be right there with them.

Folks, that's it for this week's Financials show. Questions, comments, you can always reach us at 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. Today's show is produced by Dan Boyd. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!