How Big Banks Will End: Not With A Bang But A Whimper

While we may not see another collapse of the financial system like that of 2008, that doesn’t mean big banks (NYSE:KBE) will remain strong, according to SmartMoney’s Jack Hough, who says banks face slowing growth, and shrinking importance within the global economy.

Currently the financial system has “more equity, more capital, stronger liquidity buffers and less leverage” than it did in 2008 at the height of the financial crisis, according to the Securities Industry and Financial Markets Association (SIFMA). But while strong liquidity puts big banks in good condition to weather a short-term emergency, survival is not the same thing as growth, says Hough.

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And as the economy stagnates, so too does the financial industry. “If the economy cannot grow more than 1% to 2% a year, that’s not strong enough to get money flowing into the banking sector,” says bank analyst Todd Hagerman of Sterne Agee & Leach, who says that consumers won’t borrow or spend as much when the economy is weak. “The best banks can do in that environment is low single-digit growth, and that’s not good enough to produce returns for shareholders.”

That fact is reflected in bank stocks. While many banks have recovered somewhat from the financial crisis, it would be hard to call any of them healthy when compared to their younger selves. Bank of America (NYSE:BAC) shares currently trade for $7.44, down 25.45% in the last month, down 44.12% for the year to date, and only a small fraction of a peak $55 a share in 2006. Bank of America shares were trading for three to four times what they are now at the beginning of the last decade.

While not all banks have witnessed Bank of America-sized losses, their stocks are still under-performing when compared to pre-crisis levels. JPMorgan (NYSE:JPM) shares are down 16.63% in the last five years, Goldman Sachs (NYSE:GS) shares are down 22.37% in five years, Wells Fargo (NYSE:WFC) shares are down 28.58% in that same time, and Citigroup (NYSE:C) shares are down a whopping 93.70%. At the end of December 2006, Citigroup shares were trading at a record high $557. Rallying after the huge market sell-off following the S&P downgrade, the shares are now trading at $29.96 each.

And part of the recent sell-off could be permanent as banks settle into a less significant role in the economy. Since World War II, banks and insurance companies have increased their contribution to the gross domestic product from 2.4% to 8.4%. Banks weaved themselves into the very fabric of the American life, and have been at least partly responsible for America’s high standards of living. Mortgages allow workers to essentially trade future labor for homes, while shares allow individuals to benefit from the growth of different companies while actually helping those companies to grow, creating jobs and putting more money into the economy.

But Thomas Philippon, a finance professor at New York University’s Stern School of Business, says there is strong variation in the importance of banks in the economy. According to Philippon, the best period for bank profits has been when economic growth is being driven by young, cash-poor companies. Historically, the biggest surges in bank income followed advances in industry, like the rise of railroads at the end of the 19th century, and bringing electricity into homes in the 1920s. A decade ago, the power of banks relied on technology companies with burgeoning profits during the dotcom bubble.

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After the bubble popped, Philippon says profits should have fallen, but for some reason stayed high. Services provided during the real estate bubble were not worth the price, says Philippon. Now it seems banks are finally settling where they should be, with economic growth slowing to a more moderate pace. If one is to follow Philippon’s logic, then bank profits and share prices are unlikely to recover pre-recession highs any time soon, and their role in the economy will remain that of a bit player until another period of technical advancement makes them important again.