The bank problem in a single chart | FT Alphaville

The bank problem in a single chart

In the wake of Obama’s dramatic financial reform proposals, released last week and aimed at breaking up the biggest banks, Deutsche Bank strategist Jim Reid is reprinting an updated version of one of his most controversial charts:

When Reid last looked at that graph, in July 2008, he was concerned about one thing — a sharp reversion of bank profits back to that nominal GDP-mean, something he dubbed “The Trillion Dollar Mean Reversion” :

The US Financial sector has made around 1.2 Trillion ($1,200bn) of “excess” profits in the last decade relative to nominal GDP.

So mean reversion would suggest that $1.2 trillion of profits need to be wiped out before the US financial sector can be cleansed of the excesses of the last decade.

Now, however, that 2008 mean reversion has been erased with stellar 2009 profits for the banks.

Which means, the problem of the financial system has switched from short-term losses to long-term profits. Regulators and politicians, like Obama and Volcker, are left with the unenviable task of figuring out the appropriate `size’ of the financial sector relative to the rest of the economy.

Here’s Reid’s latest commentary:

One of our most used, requested and controversial charts of the last three years neatly explains the recent furore over the regulation of the banking sector. The chart is the one we called “The Trillion Dollar Mean Reversion” and today we republish it to frame the discussion on President Obama’s aggressive plans to regulate banking activity.

Indeed when we looked at this chart in 2007/2008, the world made very little sense to us. Over a decade Financial profits had decoupled from history, the rest of the economy and reality. A combination of moral hazard issues after LTCM, the repeal of Glass-Steagall and ultra low interest rates had allowed the imbalances to get ever greater, finally leading to the collapse of many financials and what would have been the collapse of the old economic system had the authorities not been so very aggressive in their intervention.

In all honesty 12 months ago we felt that the banks would likely become more utility-like in their profitability and their earnings would oscillate around their longrun trend – a level they had reverted back to after all the write downs. So the size of the surge in profitability in 2009 perhaps surprised us more than the ‘shock’ writedowns did in 2008. With hindsight its clear that had financial profits not rebounded in the manner they have done over the last 12 months then the Global Economy would still be mired in a deep recession with the risk of Depression high. The footprints of the ever larger size of the financial sector is all over the Global economy and to leave financial earnings back down at trend levels would be to leave a trail of destruction in the real economy. So whether it was luck or judgement, allowing financial to return to super-normal profits again (see chart) allows the economy to resemble 2007 in many ways. Previously we’ve dubbed this 2007-lite.

However now the tougher battle begins. The Global economy would be better served by slowly bringing down the size of financials and weaning the global economy off its reliance on the sector slowly over time. However that would allow the sector to still be making larger than trend profits for many years to come which as Politicians are finding is very difficult to sell to an electorate baying for blood. There’s no doubt that Politicians would gain short-term popularity by increasingly regulating the industry, however they would also run the risk of cutting short the recovery. There are no easy solutions. In reality the mistakes were made in 1998 (LTCM and moral hazard), 1999 (repeal of Glass-Steagall) and the early 2000s (rates too low for too long after the equity bubble). It might be that the fears emanating from last week’s announcement are overblown given the difficulty that they will find enacting them or getting them through legislative procedures, however the trend is your friend and the Global re-regulation of the financial sector is likely in the early stages. The arguments discussed above are the main ones supporting our underweight European Bank Equity call from our 2010 Outlook. If the sector could get a clear set of rules that it will operate under then its clear that there is value in certain names. However no-one knows the rules at the moment and are unlikely to do so for some time. We stay overweight sub financial debt in the credit space as we think that the authorities will ensure that these companies will be remain going concerns under their stewardship.

Related links:
“A trillion dollar mean reversion” – FT Alphaville
An interview with Richard Thaler – The New Yorker