Earnings season is upon us again. And as is usually the case, Wall Street’s biggest banks are the ones to get the ball rolling as they did yesterday. We had the likes of JP Morgan, Goldman Sachs, Citi and Wells Fargo report their latest quarterly results and it was a mixed bag to say the least.
Goldman Sachs and Citi delivered solid earnings beats, while JP Morgan disappointed with a rare earnings miss. Meanwhile, Wells Fargo fell short on revenue expectations, despite reporting better-than-expected profits.
Having said that, we’re still talking about some of the biggest banks in the world making billions of dollars in profits every quarter regardless. So, that surely must mean the US economy is doing pretty well, no? Well, not necessarily.
Just because the big banks are making billions doesn’t mean that the rest of the economy is thriving just as much. And to understand why that is the case, we need to look at how banks actually make their money.
Let’s take an example where I am the bank. I will take deposits from my customers, pay them interest and then lend that money to someone else at a higher interest rate. Assuming I pay my depositors 2% interest and charge my borrowers 7% interest, that’s a 5% difference before accounting for all the other costs. That doesn’t seem too shabby, no?
Well, that is essentially how banks earn their money from lending. And when interest rates are elevated, they can sometimes make even more – especially if their borrowing costs don’t rise as quickly. Take JP Morgan for example. The bank disappointed in terms of earnings, but still managed to generate roughly $27 billion in net interest income, up nearly 13% from a year ago.
But then, here’s the catch. The same high borrowing costs that help banks earn more can also make life harder for their customers.
Think about a family considering a mortgage to buy a house or a small business looking to expand their operations. When borrowing suddenly becomes too expensive, they might simply decide to wait. And that means fewer new loans today, which could lead to lesser interest income for banks tomorrow.
Besides that, there’s also the risk of existing borrowers struggling to repay their debts. And we’re already starting to see banks account for that. For instance, Wells Fargo had set aside roughly $1 billion for potential credit losses last quarter – up from $681 million a year earlier. Now, that doesn’t mean borrowers are suddenly struggling to repay their loans but it is something to keep an eye out for just in case.
And to be fair, loan balances are still growing for the most part and credit quality in the industry remains relatively stable. Then, there’s also the fact that big banks also make plenty of money from trading and investment banking, not just lending. And that in itself underscores why we shouldn’t take strong bank profits as a sign that everything is going swimmingly in the US economy.
A bank might be earning more from higher borrowing costs today, but those same costs could be forcing households to cut back on spending and also force businesses to put their expansion plans on hold. And if those pressures continue to build, it could eventually come back to bite the banks themselves through weaker loan demand and more borrowers struggling to repay their debts.
The bottom line is that strong bank earnings can tell us how well banks are doing and how much money they are making, but they don’t necessarily tell us how well the rest of the economy is holding up.
This article was written by Justin Low at investinglive.com.