Mere months after the financial system almost collapsed, banks are making money again. One after the other, they've reported big profits for the first quarter: $4.2 billion at Bank of America, $3 billion at Wells Fargo, $2.4 billion at JPMorgan Chase, $1.8 billion at Goldman Sachs, even $1.6 billion at Citigroup which lost $18.7 billion in 2008.
Some of these windfalls were the chimerical sums of weird accounting conventions. Citi, for example, booked $2.5 billion in gains without which it would have booked a quarterly loss because investor fears that it would go under decreased the market value of its liabilities. (Really, it's as perverse as that.) Loan losses are also still rising and could eventually swamp earnings again at many banks. But the first-quarter profits weren't entirely imaginary. As we look ahead, banks really are in a position to make money. "This is a great time to be in banking, you know," said Warren Buffett who owns shares in Wells Fargo and Goldman Sachs on CNBC back in March. "If you just get past the past." (See the best business deals of 2008.)
The past includes bad mortgage loans, collateralized debt obligations and all manner of other lunkheaded lending decisions. It was also characterized by a 15-year decline in the net interest margin, a core measure of bank profitability that is the difference between what banks pay to borrow and what they charge to lend. The net interest margin is partly a product of interest rates: banks borrow short term and lend long term, so when long-term interest rates drop below short-term rates (as happened three times in the past 15 years), margins are squeezed. But another big factor has been the rise of nonbank competitors. The barely regulated shadow-banking system of securitization, investment banks and hedge funds took lots of business away from banks. Banks responded by relying more on fee income to pay the bills, getting in on shadow banking themselves and offering easier terms on loans the latter two with sometimes disastrous results.
Much of the shadow-banking system is now gone or in hibernation. Two of its leading institutions, Goldman Sachs and Morgan Stanley, have become commercial banks. With fewer competitors, banks have a lot more pricing power, while Federal Reserve lending programs and Federal Deposit Insurance Corporation (FDIC) guarantees of deposits and bank-bond issues have sharply lowered funding costs. Net interest margins appear to be turning the corner, and as a result, it is not inconceivable that banks will be able to steadily earn their way out of their problems over the next few years.
The question is, Would that be a good thing? Many outside observers have argued that the financial system needs shock treatment, in which the government takes over more banks and forces the entire banking system to flush bad assets from its books. If you priced all bank assets at current market values, the banking system would be insolvent, the reasoning goes, so make them take the hit and then press restart. Those with actual banking experience, though, tend to be dubious about market pricing and counsel patience. "The banks have a lot of practice at working out troubled assets, and most other parts of the economy don't," says Gary Townsend, a former bank regulator and industry analyst who runs the hedge fund Hill-Townsend Capital. "So it seems to me you should leave it in the hands of the banks to manage." (See 25 people to blame for the financial crisis.)
That's looking now to be a far likelier course of action than it seemed just a few weeks ago, meaning that our banking system may survive more or less intact. This seems like a terrible cop-out, until you consider that this financial crisis wasn't initiated by the banks that is, FDIC-insured depository institutions. It was a crisis that began among and devastated the shadow banks. A few banking companies Citigroup, UBS, JPMorgan Chase did become deeply entwined in the shadow-banking system through their investment-banking arms. But banks, narrowly defined, weren't the big problem. So letting the banks, narrowly defined, squeak through reasonably unaltered might not be such a bad move.
Before the inflation and deregulation of the 1970s put an end to old financial ways, the formula for successful banking was said to be 3-6-3: bankers borrowed at 3%, lent at 6% and hit the golf course by 3 p.m. It was an inefficient, seemingly archaic system. But it allowed banks to make healthy profits without taking big risks and protected the financial system from the volatility inherent in market-based shadow banking. We've now returned, temporarily at least, to something like 3-6-3. We may want to consider making it permanent.