Banks Running Out of Runway

Brian Pretti CFA / Financial Sense

After taking a pass on official QE at the Jackson Hole soiree, once again the focus is on the FOMC meeting this week. Will they or won’t they? After last week’s not unexpectedly weak employment number where the BLS birth/death model estimate accounted for 94% of reported headline payroll gains, pundits far and wide raised their percentage bets that QE will indeed be on the Thursday FOMC lunch menu. Personally, I’m convinced weak payroll and capital goods orders as of late are due to business concerns over the as of yet unaddressed fiscal cliff concerns. But the Street remains focused on the apparent self imposed Fed mandate of employment acceleration. The first two mega-QE’s could not light the cyclical employment fire, but hey, maybe the third time is the charm, right? Regardless, we know another Bernanke inspired QE is coming at some point, despite already high food and energy prices, to say nothing of equity prices in a declining earnings growth rate environment.

The point of this discussion is not to debate QE, nor when the next round will be unleashed. I believe that with the upcoming QE, regardless of the mystery date upon which it will arrive, we now need to focus on the banking sector. Why? Because the banks, with emphasis on the very large TBTF banks, are running out of earnings runway fast. Really fast.

Think back to early 2009 as the first QE was being concocted. One of the key rationales for implementation was the thinking that if the Fed could expand its balance sheet and essentially swap fresh cash with banking sector assets, the banks would be free to lend out this new found liquidity. And given the magic of fractional reserve banking, the lending multiplier would respark the core of the modern day global economy – credit acceleration. Without dragging you through an historical retrospective, we all know that despite unprecedented QE1, QE2 and Operation Twist, bank lending in the current cycle has been incredibly subdued. Certainly this is one of the key differentiating factors of the 2009-present cycle. But this becomes very important under QE3. In one sense, based on the character of bank earnings in the current cycle, the moment of truth has arrived. Why? Because the easy earnings gains for the big banks driven by declining loan loss reserves in the current cycle is coming to an end. Couple this with ongoing net interest margin compression (thanks largely to the Fed) and the banks potentially face flat to declining earnings ahead unless lending really starts to accelerate. In fact as you’ll see in the chart below, point to point banking sector earnings have not grown over the last four quarters (FDIC 2Q Bank Report data).

In the chart below, we are looking at quarterly bank operating earnings since 2006. Alongside is the quarter over quarter change in bank loan loss reserves. You can see that in 2006 and early 2007, bank earnings were robust and additions to loan loss reserves small to almost non-existent. Certainly as we moved into 2008 and bank balance sheets became ever impaired, loan loss reserve additions spiked as operating earnings coincidentally collapsed.

continue at Financial Sense:

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