On Banks, Bigger Doesn’t Mean Badder

Editors' note: MarketMinder doesn’t make individual security recommendations. The companies mentioned here serve only to highlight a broader trend we think is worth noticing.

As big banks kicked off earnings season last week, headlines focused most on their moves to bolster loan loss provisions and management’s uncertain outlook for lending, defaults and more. But another, less-discussed aspect of the biggest US banks’ Q2 results grabbed our interest more, as they reiterate one largely unacknowledged lesson of the financial crisis. Many see megabanks’ size and diverse lines of business as a threat—a source of instability. In our view, the experience in 2008 says otherwise—and Q2 2020 results add more evidence.

After 2008’s financial crisis, many thought big, diversified banks—which some refer to as “supermarkets”—were riskier in part because they mixed multiple business lines. They thought banks that provided financial services for everything from investment banking to mortgage lending were unwieldy and hard to manage, injecting extra risk into institutions backed by federal deposit insurance. These concerns motivated aspects of 2010’s Dodd-Frank financial regulation, which imposed additional oversight and capital buffers for banks—which are helpful enough, we guess, as that extra capital has shored up the industry to an extent. It also included the so-called Volcker Rule. When implemented in 2015, it sought to restrict banks’ proprietary trading using depositors’ money. While there is little to no evidence trading played any significant role in causing the financial crisis, many argued it was a potential source of instability. Since deposits are FDIC insured, the thinking went, banks shouldn’t have a free hand to trade their own account, capturing the upside, while putting a big part of the risk of failure on taxpayers. But proprietary trading was always hard to define, as few wanted to ban hedging and other risk management trades. Hence, the rule that took effect bore little resemblance to the strict ban many regulators envisioned early on and didn’t prevent all proprietary trading at big banks—a fact some still see as a risk to the financial system.

This always struck us as odd, considering the financial institutions that failed or disappeared through shotgun weddings in 2008 were generally less diverse. AIG was an insurer. The rest were mostly pure play investment banks like Lehman Brothers, Merrill Lynch and Bear Stearns, or firms that acted primarily as savings and loans like Washington Mutual (WaMu). In many cases—three of these four examples, actually—regulators resolved these firms’ issues by arranging a marriage with a big supermarket bank or creating new megabanks. The Lehman solution that regulators abandoned at the last minute in the name of moral hazard—a merger with Barclays—would have followed the same blueprint. As for the others, JPMorgan Chase absorbed Bear Stearns and WaMu, while Bank of America married Merrill Lynch. At yearend, Wells Fargo absorbed the institution that was closest to supermarket status at its time of failure: Wachovia. (Even then, Wachovia wasn’t exactly on the order of Citigroup, which many consider the original supermarket bank. Wachovia’s retail and commercial banking business far outweighed its investment banking and wealth management operations.)

The coronavirus recession isn’t officially over, of course. But we are already seeing signs that banks’ multifaceted business models are adding to stability in the here and now. Despite megabanks’ record loan loss provisioning, strong trading supported overall profitability in Q2. JPMorgan reported record revenues driven by trading. Its Q2 securities trading revenue surged 79% y/y, while investment banking revenue nearly doubled.^[i] This helped offset a -9% y/y decline in banking revenue as it set aside hefty loan loss provisions for expected defaults.^[ii] Trading also helped Citi and Bank of America (BofA). Citi’s trading revenue rose 48% y/y in Q2, offsetting a -10% decline in banking revenue also driven by loan loss provisioning.^[iii] Q2 trading revenue at BofA increased 22% y/y, while investment banking revenue rose 57% to a record high. This helped it exceed analysts’ expectations despite core banking weakness.^[iv] In contrast, Wells Fargo—without a significant trading division despite its Wachovia absorption—saw profits fall for the first time in over a decade on extensive loan loss provisioning.^[v] Other smaller lenders aren’t faring much better. For example, commercial lenders lacking the offset from trading or other revenue streams like Comerica and CIT Group reported Q2 losses on falling revenue and rising loan loss provisions.

We aren’t arguing this means much for portfolio positioning today. Banks big and small face challenges from the interest rate and credit environments, which we think will hinder their relative performance for the foreseeable future. But in both 2020’s contraction and the financial crisis over a decade ago, big diversified banks with multiple independent revenue streams have proven these traits often add to stability—a point that cuts against the popular narrative and one we think is worth noting.