I think it's essential to remember that just about everything is cyclical. There's little I'm certain of, but these things are true: Cycles always prevail eventually.
-- Howard Marks
In the decades after the Great Depression, the bank industry fell into a slumber as it struggled under the weight of a regulatory backlash for the damage it inflicted on the country in the 1930s. Business only picked up when internal and external pressures in the 1970s rendered the then-prevailing model of unit banking obsolete.
The question today is whether the bank industry -- which, absent the intervention of the federal government, almost inflicted an identical fate on the U.S. economy in 2008-2009 -- will follow a similar path. If it does, then it seems safe to assume that bank stocks as a whole could be a bad place for investors to focus on in the years to come.
I say this because, in the short run, banking is most profitable when financial institutions can maximize risk -- by "risk," I'm referring to all types: interest rate, credit, counterparty, legal, and reputational, among others. However, risks like these are precisely the type of things that a strong regulatory presence has a tendency to curtail.
The influence of robust financial regulation can be seen everywhere nowadays. And in all respects, though particularly for the nation's biggest banks, it has made the industry less profitable.
You can see this on the balance sheet with respect to both capital and liquidity. In the wake of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, commercial lenders and other types of depository institutions have been required by the Federal Reserve to hold a larger and more liquid share of equity capital that can be used to cushion losses in future downturns.
While a larger capital base makes the bank industry more stable, it exerts the opposite effect on profitability. This is because banks are nothing more than leveraged financial institutions -- though, of course, many large lenders complement their balance sheet revenue with various types of fee income. They take a small sliver of capital, borrow against it heavily, and then invest the combined funds by making loans or buying fixed-income securities such as Treasury bonds or mortgage-backed securities. Thus, lower leverage will necessarily yield a smaller profit.
Let's say, for instance, that a bank with $100 billion in assets has leveraged its equity base by a factor of 10 to 1 -- meaning it has $10 billion in equity capital. If it earns 1.5% on its assets in any given year, then its return on equity will be 15% ($1.5 billion divided by $10 billion). By contrast, if the same bank only leverages its equity base by a factor of five, then its 1.5% return on assets will translate into only a 7.5% return on equity ($1.5 billion divided by $20 billion).
This truism goes a long way toward explaining the dramatic growth of the financial industry, which has more than tripled its share of gross domestic product since World War II. But even though capital levels had been falling since the mid-1800s, it wasn't until the second half of the last century that single-digit leverage ratios became commonplace. The trend culminated on the eve of the 2008 crisis when the nation's then-biggest bank by assets, Citigroup, held a mere $120 billion in stockholders' equity against $1.9 trillion in assets.
To say this trend has since been reversed would be an understatement. Not only do regulators demand that all banks hold more capital in the post-crisis world, they also require that the nation's biggest financial companies, known as systematically important financial institutions, retain an additional "SIFI buffer" of as much as 2.5% of risk-weighted assets. Additionally, the annual bank stress tests administered by the Federal tie capital levels under a severely adverse economic scenario to the ability to return capital to shareholders. It's no longer enough that banks have a sufficient amount of capital when times are good; they must also prove that they can exceed the minimum regulatory threshold when the economy plunges.
As a result, the bank industry as a whole has increased the amount of high-quality capital that it holds from between 7.5% and 8% of total assets before the crisis to more than 9% today. While that might not seem like much on a percentage basis, it equates to an increase of more than $500 billion in absolute terms.
And it's not just the quantity of capital that is weighing on profitability; it's also the composition of that capital. New rules that govern liquidity require banks to dedicate a larger share of their assets to high-quality holdings such as deposits at the Federal Reserve and government securities, both of which can be readily converted into cash even if the credit market were to seize up as it did in 2008. In the eight years before the crisis, 27% of the bank industry's assets were in the form of cash, cash equivalents, and marketable securities. Today that figure is 35%.
From the standpoint of stability, this is undeniably a step in the right direction. Contrary to popular belief, most banks don't fail because they're insolvent -- that is, because they have more liabilities than assets. The problem instead is that they can't convert illiquid assets into cash quickly enough when creditors and depositors withdraw funds en masse. This is known as a liquidity crisis, and the only way to head one off at the pass, so to speak, is to require that banks hold higher reserves of cash and government-backed securities -- both of which generate much lower yields than, say, a 10-year loan to a commercial real estate developer.
In sum, when you take these regulatory changes into consideration -- namely, higher capital and liquidity standards -- it's difficult to imagine a realistic scenario in which banks will be as profitable in the future as they were before the crisis. This doesn't mean certain banks won't continue to generate outsized returns. But it does imply that it might be best for individual investors to avoid the industry as a whole for the foreseeable future.
John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of Citigroup. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.