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Why Big Banks are Hurting

Ever since the Medici started banking, the industry has been very simple, long term loans from short term liabilities.This system is sound, it’s boring but it works and smart people make a lot of money doing it.However big banks in 2004 began to feel a squeeze in Net Interest Margins, the cost of consumers borrowing went down and the cost of bank financing went up. Banks decided to part from the boring model of loans, and pursue non interest income. In other words bankers are great at being bankers but not at managing hedge funds. Hence the billions of write downs that all the big banks have undergone.

 

Table 1


 

 

Non-interest income has become a more important source of earnings, especially for larger banks.

 

Ratio = Non-Interest Income / (Non-Interest Income + Interest Income)

Bank Size

1985

1990

1995

2000

2005

Under $100 Million

5.2%

5.7%

7.3%

6.7%

9.1%

$100 million to $1 billion

6.4%

5.8%

8.1%

7.9%

10.8%

$1 billion to $10 billion

8.9%

9.4%

12.8%

10.8%

14.1%

Over $10 billion

9.7%

11.9%

17.9%

19.8%

25.1%

 

Ratio is year-end median data for each asset size group.
Source:FDIC

 

 

            Structured Investment Vehicles were the method of choice for non interest income. SIV’s have become toxic to big banks balance sheets.The big banks decided to branch out into a new revenue sources, and right now it’s punching them in the mouth. This occurred because the yield curve was relatively flat in mid 2004 because inflation was so well contained. The flat yield curve hurt the profit margins of big banks, while it did not affect small banks to the same extent. As a consequence the small banks seem to have better balance sheets and the recent turmoil has affected the share price of small banks as well. Perhaps a buying opportunity is a foot.Small banks did not have a decrease in Net Interest Margins because they didn’t rely on overnight loans like the big banks. CD’s and money market accounts tend to be a large part of small bank liabilities and they change mush slower than over night rates.The NIM of the small banks was not squeezed, so they did not branch into non interest income.All the while big banks had to succumb to a decrease in NIM, and pursued exotic forms of revenue. Today the mom and pop bank on the corner seems to be much healthier than Citibank. How to trade this phenomenon, understand that the Fed is terrified that of a big bank going bust.Since over 25 percent of their income came from assets that are now virtually worthless, be skeptical of any Hawkish comments. The question is not whether the Fed will raise rates but can they raise rates?

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