Big Bank Earnings Signal End to Legal Concerns - But New Troubles Are Brewing

Big bank earnings kicked off last week at a pivotal time for the sector. And it was a mixed bag for the nation's largest banks.

Citigroup Inc. (NYSE: C) emerged as a success story. The bank grew its third-quarter sales 9.5% from the third quarter last year to $19.6 billion, and earnings-per-share (EPS) was up 13% to $1.15. This topped analysts' expectations.

Revenue fell 2.1% for PNC Financial Services Group Inc. (NYSE: PNC) to $3.8 billion, while EPS was up $0.02 to $1.79. Both numbers beat expectations.

Wells Fargo & Co. (NYSE: WFC) matched estimates, with 3.6% sales growth to $21.2 billion and a $1.02 EPS, compared to last year's $0.99.

Only one of the top five big banks couldn't beat Wall Street estimates, and that was the nation's largest: JPMorgan Chase & Co (NYSE: JPM). The banking giant did turn last year's $380 million loss into a $5.6 billion third-quarter profit. But the $1.36 EPS was just a shade below the $1.38 expectation.

Perhaps the most important of the bank earnings came from Bank of America Corp. (NYSE: BAC).

The nation's second-largest bank suffered a 1.4% sales decline, with a negative $0.01 EPS. These still beat estimates, as analysts thought steep legal penalties would hold back the bank even more.

But those losses tell a bigger story about a new era for the financial sector.

Big Bank Earnings Mark an Industry Shift

In August, BAC paid out $16.7 billion in legal fines to the feds for abusive practices in its mortgage business. It was the largest penalty the U.S. Department of Justice ever leveled against a financial institution.

The monstrous settlement was the most recent in a long line of litigation brought against banks in the wake of the financial crisis.

"It's created a lot of uncertainty for the investors to fully understand when will this be over with," Clifford Rossi, professor of the practice and executive-in-residence at the University of Maryland's Robert H. Smith School of Business, told Money Morning.

But BAC's blockbuster settlement may signal an end to the days of large legal costs weighing down bank balance sheets.

"My sense of the legal settlements issue is that they are starting to wane," Rossi said. "The big ticket government settlements are, I think, coming to an end."

However, legal troubles aside, there are still a slew of headwinds that will hamper banks for a long time to come.

Here are the three things investors should be wary of before buying in to banking...

Three Factors Will Hurt Big Bank Earnings in Future Quarters

No. 1: Low Interest Rates

Low interest rates hold back an important income stream for the financial sector.

bank investingThat's because interest rate margins, which have generally been a key indicator of a bank's profitability, have suffered.

Interest rate margins represent the ratio of interest income a bank generates to the interest it pays out.

As you can see in the accompanying chart, these margins have slumped since the U.S. Federal Reserve began pursuing a near-zero interest rate policy. A Fed-tailored low rate policy affects rates across the lending spectrum, and the interest income flowing to banks shrinks as a result.

Even Wells Fargo, a sector leader in interest rate margins, is feeling this profit squeeze.

Now, the Fed has made it clear it sees the economy improving. This seems to be setting the stage for fiscal policy tightening.

But while many expect the Fed to raise interest rates next year, fears of slowing global growth could delay that move.

Stanley Fischer, vice chairman of the Fed's Board of Governors, said earlier this month weak growth "could lead the Fed to remove accommodation more slowly than otherwise." That would mean low bank interest rate margins for more quarters ahead.

No. 2: Slower Global Growth Rate

Slowing global growth could force interest rates to stay low for a prolonged time - but there's more. The slow global growth itself is a problem for banks as well.

Citigroup is an example of a bank that could be hit hard by this, given its large global footprint. The bank is made up of its global consumer banking segment and its institutional clients group.

Consumer banking consists of credit card services, retail and commercial banking, and mortgages. The institutional clients group provides financial services to corporations, banks, and governments worldwide.

Citigroup does 48.7% of its consumer banking outside of North America. That figure jumps to 66.9% for the institutional clients group.

With such a large portion of revenue generated outside of North America, you can expect any slowdowns to be felt in the bank's topline numbers.

No. 3: Costly Regulation

You can't blame the feds for wanting to introduce a healthy dose of bank regulation after the collapse.

But at this point, regulation has gone far beyond what is necessary.

"We needed much more regulation than we had," Rossi said. "We just don't need a carpet bombing-type of regulation."

Every facet of the banking industry has been hit.

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Federal oversight is cutting into balance sheets through strict lending, high capital ratios, and steep compliance costs.

The federal government has gone into overdrive in a shallow attempt to absolve itself of its regulatory missteps that started the financial crisis.

Compliance costs now total $70.2 billion for the nation's six largest banks, up from pre-financial crisis numbers of $35.5 billion, according to data from policy analysis firm Federal Financial Analytics Inc., as reported by The Wall Street Journal.

"I think banking is going to continue to be held back because of excessive regulatory burden," Rossi said. "Just layering in all these regulations at one time makes it almost impossible for any institution to comply with all these rules and do this in a way that does not hold them back."

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