The Next Big Bank "System Shock" Is Inevitable - the Proof Is in the Earnings

Last time, we discussed the threat that the "too big to fail" banks pose to the global economy - that their size and structural weaknesses are enough to push markets to the brink.

But that's not all...

The U.S. Federal Reserve's manipulation of interest rates and regulatory pressure from the likes of the Basel Accords are impacting big banks' earnings growth across the globe. How the banks are working around impediments to their profitability could trigger the next big "system shock" along the lines of what we saw in 2008.

Today, we're going to take a look at what that "system shock" will look like, and how the big banks' Q1 2016 earnings are just more evidence that the next catastrophe is inevitable.

Take a look...

What the Next "System Shock" Will Look Like

big bankMuch tougher capital requirements and liquidity set-asides, like what the FDIC is now requiring of U.S. banks and foreign banks with operations in the United States, are part of the Basel III Accord, which subjects all big banks to similar constraints on their ability to generate the same revenue they used to when capital requirements, reserve requirements, and liquidity mandates were considerably lower, or nonexistent.

In addition to structural, business-model, and capital and liquidity issues big banks face, they are prone to potentially catastrophic systemic shocks.

Any big bank considered to be on the verge of failure would suffer immediate "reputational risk," causing the bank's equity cushion, in the form of its stock price, to plunge and precipitate a bank run as depositors flee and funding sources evaporate.

Not only do all big banks face individual reputational risk, all big U.S. and big European banks are counter-parties with each other on trillions of dollars of derivatives trades.

Systemic risks impact all big banks almost equally on account of interconnectedness in terms of interest rate risks, credit risk, derivatives risks, syndicated loan risks, and concentration risk resulting from most of the world's big banks plying the same trades, going after the same business lines, relying on the same liquidity measures, the same types of capital, and each other.

The impact of systemic risk across all big banks is front and center in the banks' first-quarter 2016 earnings reports.

They've all claimed "volatility" affecting all the markets and business lines they all rely on for revenue, impacted their earnings.

Looking at big banks' earnings in Q1 2016, seeing how interconnected they are and how they are all subject to the same systemic and structural risks, is a good indication that their difficulties, because of their size and the need for central banks to continue to support them, is having a huge impact on global economic growth.

Big Bank Earnings Are a Huge Red Flag

In the United States, it's no surprise that the big six American banks - JPMorgan Chase & Co. (NYSE: JPM), Bank of America Corp. (NYSE: BAC), Wells Fargo & Co. (NYSE: WFC), Citigroup Inc. (NYSE: C), Morgan Stanley (NYSE: MS), and Goldman Sachs Group Inc. (NYSE: GS) - all managed to beat analysts' steeply ratcheted-down earnings estimates for the first quarter, providing a positive spin for management.

But underneath those dubious headline earnings reports, only Wells Fargo had a positive uptick in only one measure of the bank's health.

JPMorgan reported earnings per share of $1.35 versus analysts' average EPS estimate of $1.26. But revenue fell from $24.1 billion in Q1 2015 to $23.2 billion. Net profit fell from $5.9 billion to $5.5 billion. Trading revenue fell from $5.8 billion to $5.2 billion. Return on equity was 9%.

Bank of America reported earnings per share of $0.21 versus analysts' average EPS estimate of $0.20. But revenue fell from $20.9 billion in Q1 2015 to $19.5 billion. Net profit fell from $3.1 billion to $2.7 billion. Trading revenue fell from $3.9 billion to $3.3 billion. Return on equity was 4%.

Wells Fargo reported earnings per share of $0.99 versus analysts' average EPS estimate of $0.97. Revenue rose from $21.3 billion in Q1 2015 to $22.2 billion. But net profit fell from $5.8 billion to $5.5 billion. Trading revenue fell from $0.4 billion to $0.2 billion. Return on equity was 12%.

Citigroup reported earnings per share of $1.10 versus analysts' average EPS estimate of $1.03. But revenue fell from $19.7 billion in Q1 2015 to $17.6 billion. Net profit fell from $4.8 billion to $3.5 billion. Trading revenue fell from $4.4 billion to $3.8 billion. Return on equity was 6%.

Morgan Stanley reported earnings per share of $0.55 versus analysts' average EPS estimate of $0.46. But revenue fell from $9.9 billion in Q1 2015 to $7.8 billion. Net profit fell from $2.4 billion to $1.1 billion. Trading revenue fell from $4.1 billion to $2.7 billion. Return on equity was 6%.

Goldman Sachs reported earnings per share of $2.68 versus analysts' average EPS estimate of $2.45. But revenue fell from $10.6 billion in Q1 2015 to $6.3 billion. Net profit fell from $2.8 billion to $1.1 billion. Trading revenue fell from $5.5 billion to $3.4 billion. Return on equity was 6%.

While the big numbers were all mostly negative, they don't give a clear picture of the actual stresses these banks felt from hits to their big revenue-producing areas, the business lines where revenue generally can amount to as much as 60% of earnings.

For example...

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JPMorgan's earnings, in spite of beating analysts' estimates, were actually down 16%. Investment banking revenue fell 24% on lower debt and equity underwriting. Fixed-income trading revenue was down 13%, and equity trading revenue was down 5%.

Bank of America's earnings were actually down 25% on the quarter. Investment banking revenue was down 22%. Fixed-income trading revenue was down 17%, equity trading revenue was down 11%. Net interest margin (NIM) dropped 2.6%. And the bank increased its credit loss provision from $9 million to $553 million, mostly based on impaired energy-related loans.

Wells Fargo fared better than all other big banks in the quarter. While Q1 profits were down 5.9%, revenue rose 4.3%, and total loans rose 10% on strong consumer demand. NIM fell slightly from 2.95% to 2.9%. And the big energy lender charged off $204 million of energy loans, an increase of 75% from Q4 2015. But Wells comforted investors identifying only 2% of its loan book being exposed to energy.

Citi's earnings were down 27%. But while loans and deposits grew, investment banking revenue was down 27%. Trading revenue was down 15%, with fixed-income trading down 19%.

Morgan Stanley's earnings were down 53%. Investment banking revenue was down 34%. Fixed-income trading revenue was down more than 54%. Equity trading revenue fell 9%. And wealth management revenue, typically Morgan Stanley's strongest division, fell 4%.

Goldman Sachs' net earnings fell a whopping 59.9%. Trading revenue fell 37%, with fixed-income, commodities, and currencies trading revenue falling 47%, and equity trading revenue falling 23%. Advisory fees were down 20%.

Besides the big six U.S. banks, the rest of America's sizable banks also suffered through the first quarter.

But American banks haven't fared nearly as badly as all the big European banks...

Things Across the Pond Are Even Worse

Earnings at big European banks have been dismal.

In 2015, the 12 largest European banks earned $0.18 on every $100 of assets, while their American counterparts earned an average of $0.92 on every $100 of assets.

In 2015, Credit Suisse Group AG (NYSE ADR: CS), Deutsche Bank AG (NYSE: DB), and Royal Bank of Scotland Group Plc. (NYSE: RBS) all lost money. Royal Bank of Scotland has lost money every year since 2008.

The price of credit default swaps, insurance against their default and bankruptcy on big European banks in the first quarter of 2016 doubled.

According to the IMF, European banks - which lost over $600 billion in the mortgage meltdown of 2008 - are sitting with just over $1 trillion in bad debts on their balance sheets.

Some 20% of the "assets" on Italian banks' balance sheets are "impaired" or in default.

As earnings roll out from big European banks, Europe and world markets are reeling.

Deutsche Bank's profits are down 58%, and its revenue is down 22%.

Barclays' profits are down 7%, and revenue is down 13%.

Earnings and revenue at the rest of Europe's big banks are coming in somewhere between Deutsche Bank's and Barclays', but are generally terrible.

Eight years after the credit crisis, most big American banks and almost all big European banks are relapsing in spite of extraordinary central bank efforts - not to stimulate economic growth, but to liquefy and engineer profits for the big banks.

One reason global growth's been so anemic is that big banks have been the recipients of central bank largess, which was supposed to trickle down into economies as cheap loan money to spur demand, production, and economic growth.

But that hasn't happened to any meaningful degree.

Because the world's big banks are in constant need of central bank backstopping, and use central bank asset purchasing schemes to enrich themselves instead of increasing the velocity of money throughout the world, economies lack the capital they need to grow.

As long as big banks pose colossal risks to the global economy and draw tens of trillions of dollars of central bank spending (which they mostly hoard on their balance sheets to survive and thrive) away from productive economic use, global growth will continue to stagnate, until it contracts dramatically and implodes the big banks all over again.

In the meantime, big banks are going to pursue earnings growth at all cost.

They're already being accused by some analysts and regulators of end-arounding stricter capital requirements by reclassifying assets as less risky (reducing the amount of reserves and capital they have to set aside) via changes in how they "mark" their assets against internal risk models.

Given their size and the need for economies of scale, big banks will increasingly push the limits of regulations, trading, product development, and leverage to grow their earnings and profits to flush-up bankers' bonus pools.

The only way to escape the financial terrorism imposed on countries by big banks and their government-sanctioned central bank backers is by breaking them all up so they're not too big to fail.

Only by breaking the stranglehold central banks and mega-bank oligopolies have on the entire world will credit be freed up and capital markets be free to perform their function of allocating capital and credit.

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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