Bank of America's struggles to earn a respectable profit since the financial crisis underscore the role that liquidity plays in bank earnings. Image source: iStock/Thinkstock.
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As someone who reads, thinks, and writes about banks almost every day, I'm still getting my head around the lasting impact that the increasingly burdensome post-financial crisis regulatory regime will have on the industry's profits going forward. It's still too early to predict what things will look like once all the rules and regulations passed in the wake of the crisis are fully implemented, but a glance at Bank of America's balance sheet shows one important way that profitability has been impaired.
The concept of liquidity is central to banking. Banks earn money first and foremost by borrowing funds from depositors and wholesale lenders, and then investing those funds into higher-yielding assets, such as loans and debt securities (i.e., bonds). The yield a bank earns on a particular asset class is determined in part by liquidity -- that is, the ability to convert them into cash quickly. Assets that are less liquid, like loans, yield more than assets that are more liquid, like money that's on deposit at the Federal Reserve.
In Bank of America's case, its loan portfolio yielded 3.67% last year. That compares to the 0.27% yield that it earned on money deposited at the Fed and other central banks around the world.
Data source: Bank of America's 4Q15 financial supplement, page 13.
One way for Bank of America to increase its revenue and earnings, in turn, is to decrease the liquidity of its asset portfolio. This is done by increasing the percentage allocated to loans and debt securities relative to cash and money on deposit with other banks. This makes a bank riskier, as loans aren't as safe as cash, but it also makes a bank more profitable.
The problem insofar as liquidity goes, however, is that the post-crisis regulations require the nation's biggest banks, including Bank of America, to do just the opposite. In an effort to stave off future bailouts, federal regulators now require banks to not only hold much more capital than they did before the crisis, but also to allocate a larger share of their asset portfolios to highly liquid assets.
You can see this change by comparing the allocation of Bank of America's earning assets in 2007 to last year:
Data source: Bank of America and author's calculations.
There are two trends to note here. The first is that Bank of America decreased the proportion of its asset portfolio that's allocated to trading account assets by six percentage points. As opposed to reinvesting the proceeds, it deposited them at the U.S. Federal Reserve and other central banks around the world, where it earns a mere 0.27% on the funds as opposed to the 3.30% yield generated by its trading account assets.
Second, Bank of America decreased the proportion of earning assets allocated to loans. In 2007, loans accounted for 55% of its cash and earning assets. By 2015, the percentage dropped to 47%. The funds were then invested into debt securities, which yielded an average of 2.41% last year compared to a yield of 3.67% on its loans.
The net result is that Bank of America is safer today than it was in 2007, as its asset portfolio is much more liquid, but it's also less profitable, given the lower yields associated with the heightened liquidity of its asset portfolio.
The article Here's Why Bank of America Is So Much Safer Today (and Less Profitable) originally appeared on Fool.com.
John Maxfield owns shares of Bank of America. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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