Bank Profits Are Being Squeezed

U.S. banks are expanding into new areas to compensate for shrinking loan businesses, caps on credit-card charges and overdraft fees, and a ban on trades with their own money. Citigroup (C), for one, plans to hire 7,500 people in China over the next three years, double the number of private bankers in North America to almost 260, and recruit 100 commodities traders. At many banks, expenses are rising faster than revenue, eroding profit margins. "Investors would not be big fans of banks bringing down near-term returns on the promise that they'll grow revenue in the future," says Thomas Brown, chief executive officer of hedge fund Second Curve Capital in New York, which oversees about $250 million in bank stocks. "They'd rather see revenue growth out of the existing franchise."

First-half operating expenses at the six biggest U.S. financial companies by assets—Bank of America (BAC), Citigroup, Goldman Sachs (GS), JPMorgan Chase (JPM), Morgan Stanley (MS), and Wells Fargo (WFC)—grew by $7.92 billion, or 5.9 percent, over the same period last year. Revenue fell by $5.6 billion, or 2.2 percent. Morgan Stanley was the only one at which first-half revenue growth outpaced costs. The hit from rising operating costs may become clearer as the banks announce third-quarter results. JPMorgan Chase, based in New York, reported that net income rose 23 percent as loan loss provisions fell. Expenses climbed 7 percent from a year earlier, while revenue dropped 11 percent. The bank said it's on track to hire 10,000 employees this year. The rest of the top six banks report starting Oct. 18. The average estimate of analysts surveyed by Bloomberg is that profits will total $11.8 billion for the six. That would be a 20 percent increase from a year earlier, mainly because of lower loan-loss provisions, which banks count separately from operating expenses. It would be a drop of 27 percent from the second quarter. The KBW Bank Index, which tracks 24 of the industry's largest stocks, is up 13.3 percent this year through Oct. 12, compared with 6.6 percent for the Standard & Poor's 500-stock index.

Citigroup CEO Vikram Pandit, 53, has slashed costs by cutting jobs and shedding businesses, including the Smith Barney brokerage, the Primerica life insurance unit, and the Nikko Cordial securities unit in Japan. Pandit and his team have reduced assets by 22 percent in the Citi Holdings division, created last year to hold businesses tagged for exit. In the meantime, he has ramped up spending in the Citicorp division, which includes businesses he calls core to the company's stated mission of being "America's global bank." They include securities trading, investment banking, branch banking, credit cards, and corporate cash management.

First-half operating costs at Citigroup fell 1.3 percent from a year earlier to $23.4 billion, while revenue dropped 13 percent, mostly from the wind-down of Citi Holdings. Costs in the Citicorp division rose 14 percent, as revenue declined 3.6 percent. "We continue to focus on managing expenses, which includes investing in our core franchise," says Shannon Bell, a spokeswoman for the bank.

Citigroup's new spending should be monitored closely given the company's track record of ill-timed investments and inadequate risk management, says Mike Mayo, an analyst at Credit Agricole Securities USA in New York. "The burden is on Citigroup to show that it can invest for sustainable growth," he says.

The bottom line: Needing to replace lost revenue, banks are investing in new businesses, which may cut industry profits in the short term.

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