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The United States and global economic powers increasingly rely on big banks to facilitate government borrowing, fund commercial and consumer loans, underwrite economic growth, and act as originators, principals, and agents in capital markets.
Now that reliance increasingly looks to be the cause of lackluster global growth.
Today, we'll look at the size of big banks, their structural issues, and how the need to "socialize" their losses, because of their size, fundamentally retards economic growth.
Then, on Friday, we'll examine last quarter's earnings for the biggest banks in the country, and I'll show you exactly why the big banks are headed for big trouble and how they could drag the entire global economy down with them.
Big banks aren't just big – they're gigantic. And, for the most part, they're getting bigger all the time.
In spite of huge losses incurred as a result of the 2008 banking crisis, and the often overlooked fact that most of the biggest banks in the United States and Europe were technically insolvent at the height of the crisis, big American banks have gotten bigger.
From the fourth quarter of 2007 through the fourth quarter of 2015, three of the four largest deposit-taking commercial banks in the United States dramatically increased their assets. Assets on a bank's balance sheet are loans and obligations they hope to earn interest income or fees on.
According to Federal Reserve reports, JPMorgan Chase & Co. (NYSE: JPM) increased its assets by 51%. Bank of America Corp. (NYSE: BAC) increased its assets by 25%. And Wells Fargo & Co. (NYSE: WFC) increased its assets 211%. Citigroup Inc. (NYSE: C), over those eight years, shrunk its asset book 21%.
Acquisitions during the crisis powered asset increases. JPMorgan acquired Bear Stearns on April 1, 2008, and Washington Mutual on Sept. 26, 2008. Bank of America acquired Countrywide Financial on July 1, 2008, and Merrill Lynch on Sept. 14, 2008. Wells Fargo acquired Wachovia Bank on Oct. 3, 2008.
Giant European banks, having slimmed down since the crisis, due to government rescues, nonetheless acquired insolvent banks across Europe during the crisis.
The net effect of giant Dutch bank ABN-AMRO being carved up with almost half going to Royal Bank of Scotland, and Britain's HBOS being partially sold to giant UK bank Lloyd's TSB, was that the British government had to take over both Royal Bank of Scotland and Lloyd's on Oct. 13, 2008.
During and after the crisis, hundreds of small banks went out of business across the United States and Europe, and huge banks like UBS and Anglo Irish Bank were taken over by the likes of the Swiss National Bank, the Federal Administration of Switzerland, and the Government of the Republic of Ireland.
Still, none of the giant banks in the United States or Europe were flat-out liquidated. Most of the big household name banks are still intact, having seemingly survived on their own. Some were absorbed by larger institutions and some were bailed out by their home governments and are ongoing banking concerns today.
Saving big banks, as opposed to liquidating failed enterprises and morally corrupt institutions, or breaking them up, institutionalizes moral hazard, "a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost."
And the de facto doctrine that bigger banks are better institutionalizes:
- Too big to fail (TBTF)
- Too big to jail
- Too big to control
- Too big for the greater good of the economy and free markets
U.S., European, and Asian banks, especially giant Chinese banks, while too big to fail, can still become insolvent, making the world's reliance on them as underwriters of economic growth a clear and present danger to economic growth.
Below is a list of the largest banks in the world as of year-end 2015, by assets:
|Industrial & Commercial Bank of China||$3.426 trillion|
|China Construction Bank Corp.||$2.831 trillion|
|Agriculture Bank of China||$2.745 trillion|
|Bank of China||$2.594 trillion|
|Mitsubishi UFS Financial Group (Japan)||$2.455 trillion|
|HSBC Holdings (UK)||$2.409 trillion|
|JPMorgan Chase (U.S.)||$2.351 trillion|
|BNP Paribas (France)||$2.180 trillion|
|Bank of America (U.S.)||$2.144 trillion|
|China Development Bank (China)||$1.897 trillion|
These Deep Structural Issues Could Lead to Catastrophe
Mega-banks face both business-model structural issues and risks, as well as systemic and existential macro-impact issues and risks.
Business-model structural issues include: economies of scale, interest rate constraints, corporate culture, competition, compensation, and regulatory risks.
Systemic and existential macro-impact issues include: reputational risk, interconnectedness, counter-party risk, concentration risk, and volatility risk.
Business-model and systemic issues and risks are increasingly evident and reflected in big banks' earnings, which you'll see soon.
Economies of scale, or the "cost advantages that enterprises obtain due to size, output, or scale of operation, with cost per unit of output generally decreasing with increasing scale as fixed costs are spread out over more units of output," begins to work in reverse for giant banks that face equally large competitors and alternative solution providers.
Mega-banks' massive fixed and variable costs have to be met with increasing revenue from interest income, fees, and revenue from market operations. Achieving revenue of scale requires big banks to make larger and larger loans and make more loans across a wider array of borrowers.
Both making large loans to single-borrowers and making more loans across a wider spectrum of borrowers with different credit profiles increases big banks' exposure to fluctuating credit cycles, borrower-class specific risks, and recessions.
In banking, there's no such thing as increasing revenue without increasing risk.
Whether it's taking more borrower and credit risk, or taking more market and trading risks, the bigger banks have to take more risks to achieve revenue to scale.
The Biggest Threat to the Banks (You Can Guess Who's Behind It)
The biggest threat to traditional commercial and consumer banking today, which impacts big banks exponentially harder than regional and smaller banks, because of their need for huge revenue streams, is central banks' manipulation of interest rates.
Big banks have lost control of their ability to price their credit exposure in terms of the interest they charge borrowers because central banks now dictate interest rates across entire economies.
When central banks dictate low to zero, and in some countries negative national interest rate policies, banks have no choice but to adjust their interest rate charges accordingly.
The net result of artificially manipulating interest rates down is that banks' net interest income, or net interest margin (NIM), the interest differential between banks' cost of money and the rate they're able to lend at, reduces their margins, their cushion against credit impairment, and their profitability.
Big banks face increasing competition from other big banks, regional banks, shadow banks (hedge funds, private equity shops, non-bank lenders, insurance companies, social media sites), and online lending platforms.
As big banks get bigger and increasingly compete against each other to get bigger to try to generate revenues of scale by charging more and higher fees, they will increasingly drive business to new competitors offering services at reduced costs.
Corporations who used to borrow hundreds of billions of dollars from banks increasingly turn directly to bond markets to borrow, bypassing banks, except for "investment banking" fees issuers pay when banks underwrite their debt offerings.
Hedge funds and private equity companies are increasingly making direct loans to big borrowers to facilitate other corporate business and leverage borrowers' balance sheets once they've take an equity stake in them in order to pay themselves dividends and management and other fees.
Online platforms are proliferating and changing banking dynamics for commercial borrowers, consumers, and traditional lenders.
Regulatory Pressures Are Building
Besides central bank interest rate constraints and competition, increasing regulatory burdens are forcing wholesale changes at big banks.
New capital requirements and proprietary trading limits, both domestically mandated by country-specific regulatory agencies and international capital standards and requirements established under Basel Accords, are dramatically impacting big banks' revenue streams.
In the United States, Dodd-Frank rules and regulations have crimped big banks' proprietary trading, their allocation of capital to hedge funds, and increasingly subjects allowable trading operations to tighter capital requirements, increased liquidity measures, and restrictions on the "quality of capital" earmarked for trading operations.
The Federal Reserve and FDIC recently called all but one of the country's biggest banks' "living wills" – bank plans to liquidate themselves in an orderly fashion in the event of their insolvency in lieu of court-directed bankruptcy – "not credible."
JPMorgan, Wells Fargo, Bank of America, Bank of New York Mellon, and State Street Banks' living wills were rejected by both the Fed and the FDIC. Morgan Stanley's living will was failed by the Fed but passed by the FDIC. Goldman Sachs' living will was failed by the FDIC but passed by the Federal Reserve.
Only Citigroup passed muster with both regulators. The banks that failed have until October this year to resubmit their living wills with changes mandated by the regulators, who criticized failed banks and leveled "harsh feedback" in letters that ranged from nine to 30 pages to the banks.
In addition to ongoing battles over increasing capital requirements resulting from Dodd-Frank, the FDIC is now mandating a new long-term "net stable funding ratio" on top of the short-term net stable funding ratio that requires big banks to have enough "high-quality liquid assets" to be able to continue operations for 30 days in the event of an emergency. The new long-term ratio requires banks to set aside enough high-quality liquid assets to guarantee the banks will be able to operate for one year from the onset of a "banking emergency or crisis."
On Friday, we're going to dive deep into the big banks' earnings, and I'll show you exactly why they pose such a threat to the global economy.
Don't Get Scammed During Earnings Season: Wall Street's playing with your money and nearly everyone's in on it. The game is "hide the earnings" and shockingly, it's perfectly legal. Don't worry – you can cut through the deceit and protect your money from Wall Street's con with this easy calculation…
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.
He helped develop what has become known as the Volatility Index (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 10X Trader, Shah presents his legion of subscribers with the chance to earn ten times their money on trade after trade.
Shah is also the proud founding editor of The Money Zone, where after eight years of development and 11 years of backtesting he has found the edge over stocks, giving his members the opportunity to rake in potential double, triple, or even quadruple-digit profits weekly with just a few quick steps.
Shah is a frequent guest on CNBC, Forbes, and Marketwatch, and you can catch him every week on Fox Business's "Varney & Co."
He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.