A Bad Situation Getting Worse, the US Banking Profitability Crisis

This might not be the most suitable time to discuss a potential crisis in the banking industry. We are all familiar with the news grabbing profitability figures that many banks have announced in recent years. However, while the news suggests that the industry is experiencing positive momentum, closer examination reveals an issue of fundamental macro profitability concealing a dangerous shift away from sustainable profitability. Real banking revenue has been flat and is experiencing limited growth.

In a recent published study, called “A bad situation getting worse – The U.S. banking profitability crisis” which builds on the broad themes of our earlier work “The emerging crisis in U.S. banking profitability” published in 2004, we have undertaken a detailed analysis of the financial results and trends in the U.S. banking marketplace.

The study finds that there is a fundamental shift in industry revenue generation from interest-income towards increasing fee-income as a percentage of total income, with its associated focus on proprietary trading (among those firms that are capable of providing capital market services). Amid inadequate operational leverage and industry compensation dynamics, this revenue shift continues despite its limited ability to release pressure on profitability. Basically, the improvements in industry productivity are insufficient to offset the constrained revenue dynamics of banking.

As with the previous study, some of the findings are quite startling. The key findings include:

i) Banking profitability is caught between a high, largely inflexible fixed cost base unable to be flexible enough to cope with slower growing revenues and faster growing expenses.

• Projected revenue and cost growth suggest expenses will outstrip revenues between now and 2007, which will be the first time this has happened for almost thirty years.
• Bank revenues continue to shift from interest generated sources to fee-based sources.

ii) Projected average profitability growth is declining and 2007 will likely mark the start of a profit compression that could leave some banks seriously exposed to underlying market conditions.

iii) Business models and strategies are important considerations as banks that are predominantly reliant on corporate and institutional fee-based businesses continue to consistently under perform against their interest-income oriented peers.

Based on these findings, we believe that banks are not effectively focusing their strategies in response to shifting revenue streams, and are failing to value and evaluate their revenue generation techniques.