Q4 Bank Earnings Won’t Matter — But This Is What Will

financial failures

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Tomorrow, JP Morgan will kick off earnings seasons for American banks.After that, next week is filled with banks reporting fourth quarter and full year results.

Will the actual results matter? Do fourth quarter bank earnings really matter?

They won’t for two key reasons, each of which can be boiled down to the following: business is bad and there doesn’t seem to be any spark to ignite.

Both of these facts are well known by the market and arguably baked-in to their shares.

1) It has been a bad year for banks generally and individual shares specifically.

Trading never really picked up in volume or profitability.

The global economic growth didn’t pick up and the European sovereign debt crisis hampered confidence.

Layoffs were announced and executed at major firms. 

And it wasn’t just the rank and file. Senior bankers have been departing as well as the fiscal year ends.

Bank shares were the worst performers in the S&P 500, down 20%.

2) It is unclear where growth in revenue or earnings will come from in 2012.

Banks can’t count on riding a surging global economy to improved profitability. Global growth may increase in 2012, but it’s definitely not a sure thing and far from the consensus view.

Add to that, increased regulation is on the horizon domestically and globally and banks still face the hangover of pending or potential lawsuits and settlements for pre-crisis behaviour.

As a result, rumours abound of larger, strategic moves as banks seek some way to grow revenues and earnings. Maybe Goldman will make a big acquisition in investment management? Or it won’t.Perhaps Bank of America will profit from a new government mortgage refinance plan? Or it might need to recapitalize.

Citi recently failed to find a bidder for its consumer lending unit

Of course, analysts have increased their trading forecasts for banks in 2012. But for an opaque, volatile, high-volume business, the question can rightly be asked, “exactly how does one forecast improved trading results?”

As if to reinforce this, Wells Fargo was the best performing large bank stock in 2011. It is also the least reliant on investment banking or trading.

The bottom line: 2011 was a tough slog and if 2012 offers more of the same, bank stocks will continue to languish. 

However, if the economy starts to pick up in the coming year, banks, with a business model leveraged to GDP expansion, could outperform big time.

So instead of looking at headline revenues and earnings, look to these metrics:

Return on equity (ROE): ROE was one of the biggest drivers of bank stocks’ rise pre-crisis but it has been compressed since and is a metric that is always scrutinized. But it’s particularly relevant now, because of looming capital requirements. If banks cannot turn around steadily decreasing ROE, their shares will remain depressed.

Book value: book value is another metric bank investors are always quick to look at. It becomes even more important when rumours of impending recapitalization’s (B of A, anyone?) are swirling.

Compensation set aside: these will of course be lower than in boom years, but if banks drop discretionary comp levels significantly, it’s not just a signal that they understand the public’s discontent with the financial industry. It’s a clever recognition that their employees don’t have many options to move. Employee mobility is generally a sign of a strong industry. 

Geographic distribution of revenues: banks have been talking up the promise of emerging markets growth for years (BRICs, anyone?) Are they being able to grow their businesses in these countries? If not, they may be missing a chance to capitalise on a huge chunk of whatever global growth is generated in 2012.

Business unit contribution to earnings: regulators are sending strong messages about what types of businesses they want large banks engaged in and the extent of their profitability. How are banks responding? Still being reliant on sales and trading for a hefty chunk of earnings is not a good thing right now.

Qualitative views on global growth: while these should be heavily discounted, as bank executives either sandbag their true views or are often, like the rest of us, wrong, a CEO or CFO’s view on the global economy may tell you something about how the bank will position itself in the coming year.