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These have been flush times for U.S. banks. This year, they most likely will beat last year's record profits of $120 billion -- thanks to the lowest interest rates in decades and spending by indefatigable consumers, whose transactions account for two-thirds of bank revenues.
Yet the end of Easy Street may be near. Costs for everything from upgrading bank branches to fighting lawsuits and complying with tighter regulations are spiking. Technology expenses alone are rising 6% a year as the need to upgrade computer systems from past acquisitions becomes pressing. At the same time, revenues are taking a hit as interest rates edge up, hurting the mortgage-refinancing and bond-trading businesses. "Banks have seen windfall profits these last few years," says Nick Studer, head of consultant Mercer Oliver Wyman's corporate and institutional banking practice. "They're thinking that they've got a business full of good athletes, but in fact they've been running downhill."
Megamergers have bought banks growth and time before -- now both are running out. "Banks have spent a lot of money to get a lot bigger, but they aren't much more efficient," says Adam Dener, author of a study called The Emerging Crisis in U.S. Banking Profitability and a partner at Capco, a financial services consultancy. "As a result, they now face a business model impasse."
Analysts are pruning their earnings estimates. They figure that earnings for the 1,339 companies in the Dow Jones Bank Index will grow a meager 4% this year, down from 8% six months ago, says Thomson Financial. Next year's numbers also are being ratcheted down: On Nov. 22, Andrew B. Collins of Piper Jaffray & Co. (PJC
) shaved 6% off his 2005 earnings estimate for J.P. Morgan Chase & Co. (JPM
), while John E. McDonald of Banc of America Securities (BAC
) cut his forecast for Citigroup (C
) to 4% below the consensus. That may be just the beginning. "What happens if the consumer rolls over?" asks Barry F. Kroeger, deputy director of the banking and capital markets practice at Ernst & Young. Consumers "fueled the recovery, and unless banks can replace those revenues, that's going to have a huge impact on their future."REFI RETRENCHMENT
Rising interest rates are banks' immediate worry. Long-running predictions of the end of the mortgage-refi boom are starting to come true, big time. The Mortgage Banker's Assn. forecasts refi activity will fall 55% this year, to $1.15 trillion. And higher rates could soon push depositors to move their cash elsewhere, robbing banks of cheap funding, says Capco's Dener. Bond trading, another huge profit center for banks as interest rates swooned, is also set to plummet. Banc of America analyst McDonald expects that Citi's fixed-income trading revenues will fall 8% next year -- a $681 million decline.
Meanwhile, corporations are so flush with cash that commercial lending has remained flat even despite the improved economy. Banks are losing out to rival private-equity firms, specialized outfits such as CIT Group Inc. (CIT
), and even hedge funds as the lenders of choice for small and midsize companies. The competition is stiff because borrowing by such companies -- now a $20 billion market -- is growing 8% a year, twice the rate of lending to large corporations, say consultants McKinsey & Co. The banks have largely themselves to blame for their dwindling share of this market. They alienated customers by making it tougher to get loans during the recession and also ignored them while chasing larger companies that promised lucrative investment banking and other fees -- businesses that turned out to be less profitable than they hoped.
In a telling sign of the lack of loan demand, U.S. Bancorp of Minneapolis (USB
) announced last month that it was raising payouts to shareholders. After planning to use 80% of its $1.1 billion third-quarter profit to pay dividends and buy back shares, the nation's sixth-largest bank upped that to 94%. With demand for commercial loan growth flat, it was the best the bank could do with the money, analysts say. "Banks can't deploy this capital because the market demand for their services is maturing," says E&Y's Kroeger.
While banks cast about for new areas of hot growth, costs keep climbing. With the advent of the U.S.A. Patriot Act requiring banks to set up new anti-money-laundering procedures, additional governance controls mandated by the Sarbanes-Oxley Act of 2002, and new mutual-fund rules to monitor unlawful trading, compliance costs are the biggest new expense. In fact, additional non-interest expenses -- a category tracked by the Federal Deposit Insurance Corp. that includes such costs -- rose nearly 14%, or $58 billion, in the first half of the year.
The category also includes litigation reserves, which are ballooning as the number and size of lawsuits filed against banks are soaring. Italian dairy giant Parmalat, for instance, is suing Citi and Bank of America Corp. (BAC
) for more than $10 billion each, claiming that they played a role in its bankruptcy. That's more than BofA's first-half pretax income of $9.7 billion. Both banks are contesting the suit.
One big bright spot is that loan losses are the lowest in memory. That, however, is leading banks to reduce reserves against future losses. CreditSights analyst David A. Hendler found that banks reduced their capital reserves by $800 million in the third quarter, adding to earnings. But with loan losses now below historical norms, an uptick in bad loans is inevitable, he says. "If borrowing costs spike, investors should expect sizable readjustments to credit costs," he says.
The merger wave of the last decade papered over many of these issues. Now, banks can no longer boost their earnings by simply buying another big bank. They must finally do the hard work of integrating their acquisitions to become more efficient. Many banks depend on decades-old computer systems that use archaic programming languages and pay people "astronomical salaries to keep the systems up and running," says Dan Stull, managing director of Jefferson Wells in Seattle, a financial-industry compliance specialist. "They haven't given themselves the time to merge the systems before they move on to the next deal." In fact, three-quarters of some $340 billion in tech spending by banks last year went to maintain existing systems, according to Deloitte & Touche.PAYING LIP SERVICE
Critics say that money might have been better spent on new technology and training that helps to sell more products. "Banks have paid lip service to cross-selling and managing customer relationships," says Mercer's Studer, "but most haven't done anywhere nearly enough." Wells Fargo & Co. (WFC
) is one exception: It says its typical customer buys four products, twice the industry average. But Deloitte estimates that, overall, customer churn costs banks $15 billion a year. And their apparent inability to engage customers means that banks scoop up just $1,000 of the $3,500 that the average American household spends each year on financial services.
Of course, by some measures banks are better run now than ever. Since the recession of the early 1990s, they have become adept at managing risk by using sophisticated hedges and bundling loans to sell to the capital markets. And bolstered by years of strong earnings, banks are in better financial shape than they have been for years. The huge burden of post-bubble regulations also carry an upside: It should help banks avoid the sorts of blowups that have plagued them in the past.
If banks want to keep margins up as many of their mainstay businesses shrink, they need to squeeze more value from their operations and boost productivity. "They have been living under this false premise that as they get bigger, they get better," says Tom Brown, chief executive of hedge-fund firm Second Curve Capital LLC in New York. "What the biggest banks haven't done is excel at the basics." First, they'd better get back to basics. By Mara Der Hovanesian in New York