THE BANKS AND THE FEDERAL RESERVE SEEM TO BE POSITIONED WELL / SEEKING ALPHA

The Banks And The Federal Reserve Seem To Be Positioned Well

John M. Mason



Summary


•The six largest financial institutions in the United States earned a return on shareholder's equity of 10 percent or more in 2018, the first time since before the Great Recession.

•Even with the reduction in the size of the Fed's securities portfolio, the banking system has more than $1.6 trillion in excess reserves, plenty of liquidity.

•It seems as if both the large financial institutions and the Federal Reserve are well positioned for the "uncertainties" the economy might be facing in 2019.


The one word that seems to describe the economic picture for 2019 is “uncertain.”

The current economic recovery in the United States will hit its tenth anniversary this summer, but an uncertain atmosphere surrounds the world, both business-wise and politically.

So, where does the Federal Reserve find itself at this time, and where is the banking system?

My answer to this is that the Federal Reserve and the banking system seem to be in pretty good shape for an uncertain future.

Fourth-quarter bank earnings for the largest six banks in the United States were mixed. I have written about the bank earnings in four posts during the past week.

One conclusion that can be drawn from the mixed results was that there seemed to be no common theme amongst the results of the big banks. A couple of the bank sustained poor trading results, but other than that, there was no indication of a consistent pattern.

And, there was no evidence that the fourth quarter was anything other than one unique quarter out of the four in 2018.

For the year as a whole, we got results like Morgan Stanley (NYSE:MS) hitting historic high earnings.

Furthermore, for the first time in almost fifteen years, all six of the largest financial institutions in the United States earned a return on shareholder’s equity around 10.0 percent or above.

This was truly unique and, for me, a good sign. It pointed to the fact that these banks were succeeding in transforming themselves to function successfully in the 2020s. This includes Goldman Sachs (NYSE:GS), the last of the “big six” to restructure its organization after the Great Recession, and Bank of America (NYSE:BAC), whose CEO Brian Moynihan has taken a very, very slow pace to reach a double-digit ROE in its turnaround.


There is even some evidence that Wells Fargo (NYSE:WFC) is getting its “ship in order.”

The managements of these institutions, however, are not rushing out to exhibit their new strength.

In fact, two of the largest banks have explicitly started to structure themselves for the uncertainty that lies ahead. Both JPMorgan Chase (NYSE:JPM) and Citigroup (NYSE:C) explicitly stated that they had taken steps to prepare themselves for the uncertainty that everyone was facing with regards to what might happen in 2019.

The banks seem to be very comfortable about their reserves for loan losses and each institution has a lot of cash on hand.

Thus, it seems that banks with over fifty percent of the assets in the US banking system are producing good returns, are taking a very conservative attitude with respect to running their banks, and are being very cautious about the future.

This is totally unlike the situation in Europe where the central bank admits to the fact that several countries within the community, and especially Italy, have banks with large amounts of loans and securities that need to be written down. It is incredible to hear this at a time when the European Central Bank is just beginning to move from its stance of quantitative easing.

What about the Federal Reserve’s position?

I believe that the Federal Reserve has managed itself very well, given the position it is in.

For example, the Fed’s line item, Reserve Balances with Federal Reserve Banks, a proxy for excess reserves in the banking system, totaled $1,625.5 billion on January 16, 2019.

Thus, there is plenty of liquidity in the banking system, itself. In fact, all the cash in the large banks take up a goodly share of these excess reserves.

The decline in the Fed’s securities portfolio has resulted in a decline in these "excess reserves," which stood at 2,2343.5 billion on January 17, 2018. The reduction in the securities portfolio of the Federal Reserve has been smooth and steady and has resulted in a decline in “excess reserves” without any disruptions to the banking system.


But, this is always what the Fed wanted to achieve as it has explicitly intended to err on the side of monetary ease as it conducted policy following the Great Recession. And, the Fed has been very successful in achieving this goal.

Furthermore, there seems to be very little pressure on the Fed’s policy interest rate range. For the last several weeks, the effective Federal Funds rate has remained at 2.40 percent, 10 basis points under the upper limit of the latest range for the Federal Funds rate and there appears to be no market pressure at all for this effective rate to rise.

Federal Reserve officials have indicated that they would like the range for the policy rate to be at least 50 basis points higher, but for now have argued that any further increases in the range will be very data dependent and will not take place on a signaled schedule as the past few increases have been.

Concern over future economic growth and the volatility of the financial markets, especially stock market volatility, have caused the Fed officials to back off from a more aggressive stance.

Bottom line, I think that the Federal Reserve and the banking system are positioned well right now, given what they have come through and the uncertain future they are facing. Certainly, more needs to be done.

I am comfortable with the Fed’s position right now and with the view that they need to move in the future with much discretion. Here, Fed officials must go with the “feel of the market” and must move carefully to meet the market’s needs. I don’t think the Fed should be a “leader” of markets right now.

The Fed still needs to further reduce the size of its securities portfolio and there seems to be adequate liquidity within the banking system to absorb further reductions. Still, Fed officials must not be rigid in how they continue to pursue this exercise. Given the uncertain future, the Fed still needs to err on the side of monetary ease so as to avoid disruptions to the banking system.

And the largest banks? May they continue to earn a return on shareholder’s equity of 10 percent or more and may they continue to function to the conservative side of the management practice.