One of the biggest changes to the bank industry since the financial crisis is the amount of high-quality liquid assets companies like Bank of America (NYSE:BAC) must hold in order to satisfy regulators.
In this segment of Industry Focus: Financials, The Motley Fool's Gaby Lapera and John Maxfield dig into the role that the liquidity coverage ratio plays in Bank of America's subpar performance over the past eight years.
A transcript follows the video.
This podcast was recorded on May 9, 2016.
Gaby Lapera: Bank of America, going back to our story, has purchased Merrill Lynch, and things have changed for them. No one had really thought about it, but the regulatory environment was going to have to change as a result of the financial crisis. So, the financial regulatory climate was completely different from that weekend onward, which really sucked for Bank of America. I don't know if I'm allowed to say that on air, but we're going to keep it in. (laughs)
So now, Bank of America is running into a few different things. The regulatory requirements have changed. First and foremost, liquidity coverage ratio. Second, capital requirements. Third, believe it or not, their scale is working against them, and fourth, the Volcker rule. So, let's cover that in order. Do you want to start with the liquidity coverage ratio?
John Maxfield: Yeah. Here's the issue. A bank wants to earn 1% on its assets. That's really what you need to earn in order for a bank to be able to create value. Bank of America is earning dramatically less than that. One of the reasons it's earning so much less is because its balance sheet has to be much more liquid than a regional bank, or even a large bank like Wells Fargo, but a simpler bank, because Bank of America has both investment banking operations and regional banking operations.
If you think about what a bank is, a bank is really nothing more than a leveraged fund. You have some capital, you borrow a whole bunch of money for really cheap from depositors, and then you invest that money into higher-yielding assets. The key is, if you can invest a larger chunk of that money into really high-yielding assets, and in the banking world, those are loans, then you're going to make a lot more money than a bank that's going to have to invest its money in, say, government securities, which only yield whatever it is, 2-2.5%.
So, if you look at Bank of America, one of the things you'll notice is that only 41% of its earning assets consist of loans. If you go over and look at Wells Fargo, 51% of its earning assets consist of loans.
Lapera: For our listeners, just so you know, 10% might not seem like a lot. For example, if you got a 46% on a test, and you raise it up to a 56%, you're still failing. 10% can make all the difference in the world in financial terms.
Maxfield: Yeah, 10% is huge. Let me give you some numbers to really back this up. Bank of America has $1.8 trillion worth of earning assets. So, the difference between Bank of America and Wells Fargo in terms of the percentage of their assets that are allocated through loans equates to $11 billion in annual interest income for Bank of America. So, that's basically just free money that, for all intents and purposes, falls to the bottom line after taxes are taken out of the equation. So, the fact that it has to stay so much more liquid than Wells Fargo Dallas is really impacting this bottom line. And the reason it has to stay so much more liquid is because of this thing called the liquidity coverage ratio.
The liquidity coverage ratio basically just tells banks how much cash or high-quality assets they have to hold on their balance sheets.
Lapera: High-quality liquid assets. For our listeners who may be new to investing or finance, liquid means they're easily converted into cash. Before the financial crisis, banks had a much lower threshold for the liquidity coverage ratio, because they just did. No one had to.
Maxfield: That's right. And we've seen this in basically every financial crisis in the past -- one of the main reasons banks fail isn't necessarily for a lack of capital, but for lack of liquidity. So, you have depositors that are running on a bank that want their cash very quickly. Well, a bank cannot, as a general rule, transition its assets from loans, government securities, etc, over into cash fast enough to satisfy those runs.
So, what the regulator saw was, "We need to require banks at all times to hold more liquidity on their balance sheets, and the banks that have to hold the most are universal banks, the ones with trading operations, other types of Wall Street operations, and retail operations." Their liquidity coverage ratio is much higher because the cash outflow under a projected scenario where you have a financial crisis -- they use the same kind of test that they use in the capital, the CCAR process every year, which tests capital standards -- they look at how much liquidity would flow out of a bank under a severely adverse economic scenario. And that's how much a bank has to hold on its balance sheet at any one time.
Lapera: Right. So, if you think about it, or retail bank, which is a bank that specializes in taking deposits and putting them back out again as loans, the likelihood of them losing all their capital, because of a bank run is a lot less than people pulling out of the stock market, which is what could happen to a universal bank.
Maxfield: Right. Or, even more importantly, let's say you have your universal bank like Bank of America, and you have a prime brokerage, so you serve hedge funds. Hedge funds keep a lot of money on deposit with you in order to buy and sell securities as opportunities present themselves. Hedge funds are at the cutting edge in terms of knowing what's going on in Wall Street. As soon as they hear there's a problem at a bank, they're going to pull all their money out.
So, that's where that run really starts, whereas retail deposits, with people like you and me -- well, we're a little unique because we follow banks so closely. But the average person doesn't follow banks that closely, so they're not going to know immediately when a bank gets into trouble, so they're not immediately going to run on the bank and pull that money out. So, that's that difference between your Wall Street operations and your retail banking operations from a liquidity perspective.
Gaby Lapera has no position in any stocks mentioned. John Maxfield owns shares of Bank of America and Wells Fargo. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool recommends Bank of America. 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.