A tale of two banking systems

It is morning in America for the large US investment banks, which posted strong results this week. Meanwhile, more conventional lenders are having a decidedly European moment.

Goldman Sachs, ever the alpha male of Wall Street, set the tone with net quarterly earnings of $3.4bn – its best ever as a public company. JPMorgan followed with $2.7bn. After the banks’ spell in the governmental intensive care unit, it must again feel good to be their shareholder. Goldman’s gain means a 23 per cent annual return on equity; JPMorgan’s investment bank arm achieved 18 per cent.

Such returns are stunning – and much higher than what one would expect from bread-and-butter sectors of the economy. They should not surprise as there is nothing bread-and-butter about finance these days. Risk aversion is still severe and spreads are large, creating a fertile field for those prepared to deploy their funds.

In truth such results are nothing new for the banks. Throughout the boom, high leverage boosted profits to levels that should have raised red flags. Sustained high returns usually indicate one of two things: insufficient competition or high risk. Both are plain to see in investment banking these days. The crisis cleared out much competition – and has taught us how risky banks’ activities really are.

Take a few steps away from Wall Street and the last quarter looks a lot different. Citigroup and Bank of America only got into the black on proceeds from selling off business units. Even at JPMorgan, retail banking reduced overall return on equity to 6 per cent.

The savaging of US securitisation markets, it is said, was only the first act; now the financial drama turns to bank lending in Europe. But there is old-fashioned banking in the US, too, which is now smarting from bad loans as the recession tightens its grip on family finances. CIT’s travails suggest the worst may yet be to come.

Investment banks’ profits may reignite popular outrage; still, they bring an important advantage. The more profits they make, the faster they get recapitalised – in a politically more palatable manner than through public bail-outs. But at a high cost: banks’ gain from large spreads and fees is a loss to those on the other side of the transactions. And since governments still protect the biggest banks against failure, any premium they earn is for risk carried by the taxpayer.

This is a dangerous situation. If one side of the banking system stays under water, the public will not long help the other stay afloat.

Source: FT