U.S. banks mired in trading doldrums

A major engine for profits at the largest U.S. banks is sputtering as tranquil markets and increasing regulation squeeze trading revenues.

A new round of bank earnings kicks off Friday with a second-quarter report from Wells Fargo & Co. and continues next week with a parade of trading heavyweights, including Citigroup Inc., JPMorgan Chase & Co. and Goldman Sachs Group Inc.

Analysts believe that banks experienced loan growth in the quarter and had few bad loans to grapple with, but the overall environment remained challenging. The end result is a lacklustre quarter: Only two of the largest U.S. banks, Wells Fargo and Morgan Stanley, are expected to post profit growth over a year ago, according to analysts surveyed by Bloomberg LP.

Revenues from trading – an area that once powered profits – continued to slump. Some banks have already braced investors for bad news. In May, Citigroup chief financial officer John Gerspach said he expected trading revenue to decline 20 to 25 per cent in the second quarter compared with a year earlier. JPMorgan Chase & Co. has predicted a 20-per-cent decline.

The revenue drops may not end up as severe as banks forecast earlier in the quarter, but they nevertheless point to a deeper shift in how major financial institutions generate profit. The decline in trading revenues is driven by both shorter-term and longer-term factors – and there's a robust debate about whether a turnaround is likely.

The more immediate cause is the current quietude that prevails in financial markets, where measures of volatility and trading volume have fallen in recent months. For the units of banks devoted to trading fixed income, currencies and commodities, it is a time of deathly calm.

"There is a general complacency out there," said Charles Peabody, a banking analyst at Portales Partners in New York. "People feel like there's no reason to change their positions."

The more fundamental factor at play is the restructured regulatory landscape. Banks have jettisoned the trading desks that transacted for their own benefit, as required by the so-called "Volcker rule." In good times, such units minted money for their respective banks. Meanwhile, regulations have also forced banks to lower leverage and made some types of trading less profitable.

Recently, the transformed landscape for trading revenues led one prominent analyst to downgrade his rating for Goldman Sachs. "This thoroughbred firm is currently hobbled in its largest line of business – sales and trading," wrote Brad Hintz of Sanford C. Bernstein & Co. in a note to clients last month.

"We are now convinced that the major banks' trading businesses will not recover quickly," he said. Indeed, no fixed-income trading unit at any bank is likely to produce returns to cover its cost of capital for the next two years "at least," Mr. Hintz added.

In the first quarter of this year, the world's 10 largest investment banks experienced a 16-per-cent drop in their fixed-income trading revenues over the same period a year earlier, according to a report from research firm Coalition. Equity trading revenue also declined. Revenues from stock offerings and mergers and acquisitions increased, but not nearly enough to make up for the trading declines.

The legal hangover from the financial crisis also continues to weigh on banks' bottom lines. Both Citigroup and Bank of America Corp. are reportedly nearing large settlements with U.S. authorities over their role in peddling mortgage-backed securities prior to the 2008 meltdown. The former is said to be discussing a deal worth $7-billion (U.S.), while the latter is preparing to pay as much as $12-billion.

Overall, analysts are preparing for a mediocre round of earnings and paying close attention to where banks believe their businesses are headed in the second half. RBC Capital Markets predicted that half of the U.S. banks it researches would report a decline in quarterly profit larger than 3.1 per cent compared with a year earlier.

Mr. Portales said there are several key questions he'd like to see addressed in the discussion of the most recent quarter's earnings. "Is the loan growth that we're starting to see sustainable? Are we seeing an inflection point in terms of credit quality?" he asked. "Are we going to start to see a bottoming in trading [revenues]?"

Some analysts say volatility is poised to make a comeback in the second half of the year, which could energize trading activity. Mr. Portales counts himself as a pessimist. "Some people think we've seen the worst," he said. "Trading can get weaker."