How the Government "Cut the Profitability of Banking Roughly in Half"

By Markets Fool.com

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In the middle of last week, former Treasury Secretary Timothy Geithner acknowledged that the government had "cut the profitability of banking roughly in half."

While this was a slight exaggeration, there's no question that banks are much less profitable today than they were before the crisis. From 2003-2006, the average bank earned 13.4% on its equity. From 2011-2014, that had fallen to 8.8%.

For investors, this begs two questions: How did this happen? And should we assume the drop is permanent?

The answer to how it happened is threefold. First and foremost, banks are suffering because of the low-interest-rate environment.

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Most lenders nowadays are "asset sensitive," meaning that a large share of their loan portfolios are indexed to some measure of short-term interest rates -- be that LIBOR, the Fed Funds rate, or some other pertinent benchmark. It accordingly follows that when interest rates are low, banks generate less revenue.

You can see this in the bank industry's net interest margin, which is a ratio of a bank's net interest income to its average earning assets. In the fourth quarter of last year, the industrywide net interest margin was a mere 3.1%. That's the lowest it's been since 1989.

On top of this, thanks to new legislation and regulations, the industry has also seen noninterest income contract. Banks have changed how they assess overdraft fees, debit card interchange fees have been curtailed, and of course, the drop in mortgage activity relative to before the crisis has reduced the fees associated with originating, selling, and/or securitizing home loans.

In the four years before the crisis, the industry earned the equivalent of 2.2% of its assets in fee income. In the four years since the crisis, this number has dropped to 1.7%.

Finally, banks are now being forced to hold more capital relative to their assets. While this has no impact on the amount of money a bank earns per se, it weighs heavily on a bank's return on equity, which is the principal profitability metric used to assess banks.

You can see this in the chart below. If you exclude the sharp drop during the financial crisis, banks now hold equity equivalent to approximately 11% of their assets. Before the crisis, the figure was in the 10% range, if not lower.

In terms of the permanence of these trends, there are a number of things to keep in mind. In the first place, it should be obvious that interest rates will eventually go back up. Some are even predicting that the Federal Reserve will begin raising rates this year. Suffice it to say that this will solve one of the bank industry's biggest issues.

When it comes to noninterest income, it seems safe to assume that this figure will be permanently lower. This follows from the fact that the decline in fee-based income was triggered by presumably long-eduring regulations and legislation enacted in response to exploitation of customers.

And the same is true of capital, as the regulatory consensus is overwhelmingly in favor of requiring banks to hold more capital to absorb credit losses in future downturns.

In short, as in the years following the Great Depression, it seems prudent to assume that banks will be less profitable during the foreseeable future than they were before the crisis. This isn't a bad thing, as it also implies that bank stocks will, on average, be safer. But it's nevertheless a reality that investors need to consider when thinking about bank stocks.

The article How the Government "Cut the Profitability of Banking Roughly in Half" originally appeared on Fool.com.

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