Banks are out of the ICU and have been released from the Rehab Center. But they are not yet in a position to fully resume a redefined role in society.
As analysts pour over the details of the recent earnings announcements by U.S banks, one thing is clear: The banking system has largely overcome a complex set of self-inflicted injuries. What is less clear is how banks will navigate what lies ahead.
Banks fueled the worst of the 2008 global financial crisis with a combination of three crippling, self-created problems: too little capital, too many doubtful assets and a risk-taking culture gone mad. Many were on the verge of bankruptcy, and the global economy was staring at a depression.
With exceptional public sector support from the Federal Reserve and other government agencies averting the immediate threat of large sequential failures, banks set on the road of balance sheet rehabilitation. They were pushed along the way by markets and regulators, both of which forced the banking system to de-risk, to change harmful incentives and to correct misalignments. And they responded while increasing sector concentration risks, with some large banks getting even larger.
It was far from a smooth process. In the process of bank recapitalization, some sectors of the economy faced harmful credit rationing that undermined investment in productive activities and contributed to persistently high unemployment. Meanwhile, popular anger remained high, fueled by what many considered as an overly lenient treatment by the U.S. Treasury and the Federal Reserve.
And it sure did not help that some banks were inclined to quickly resume some highly controversial practices.
The recent set of earning announcements by banks point to significant progress in overcoming the three big problems. Capital cushions are now big and deep, asset quality has improved significantly, and internal incentives are being re-aligned. In addition, banks seem to have placed part, though not all, of their litigation risk behind them.
Of course, individual institutions vary in the extent of improvement. Some (like Goldman Sachs, JP Morgan Chase, and Wells Fargo) have made very significant progress. Others (such as Bank of America and Citibank) are lagging. In aggregate, however, the sector is now well past the critical stage.
Yet, it is still too early for them to declare victory.
A THREE-STEP PROGRAM
Three major issues need to be addressed for banks to resume a normal life and regain a stable place in society; and their resolution is both consequential and still uncertain:
(1) Today's healthier banking system allows regulators, should they wish to do so, to now pursue some tricky initiatives that were essentially shelved by concerns that they would add rather than reduce systemic instability. Most important among these is the still-unresolved debate on whether and how to break up large banks that are "too big to fail," "too complex to fail, "too interconnected to fai," and"too big to manage."
(2) Regardless of where they find themselves on the size issue, banks are yet to fully re-align their operating models with current-day realities. The fall in NIMs, or net-income margins, is yet to be fully reflected in earnings. Expected returns on capital, while becoming more realistic, may still be ahead of what is attainable. And reliance on trading and capital market activities remains considerable.
(3) Then there is the even trickier challenge of restoring trust in the role of banks in a vibrant and growing economy. Because banks got off way too easily in 2009-2010 -- even escaping a windfall profit tax -- society remains suspicious of bankers and their motivations. The longer this persists, the greater the setback to a complete recovery from the global financial crisis.
HOW FAR FROM NORMAL?
Do not under-estimate the importance of these three factors. Absent their timely and comprehensive resolution, the funding of the real economy will remain sub-optimal, liquidity in capital markets will continue to contract, and gains in financial soundness will come at the cost of significant efficiency losses.
Have no doubt. Addressing the remaining challenges facing the banking system is an integral part of the multi-faceted reform initiatives needed to escape decisively this period of unusually slow growth, persistently high unemployment and recurrent debt and deficit concerns.
No one should fool themselves in believing that the recent favorable earnings announcements are an all-clear signal. Yes banks have recovered but there is still much to do before they regain a stable role in society, thus contributing to higher and more inclusive economic growth and job creation.