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Bank investors better get used to low returns

January 20, 2012: 10:30 AM ET

Reduced risk has translated into a return on shareholder's equity that's more akin to a sleepy regulated utility than a top investment firm.

By Cyrus Sanati, contributor

goldman_sachs_morgan_stanleyFORTUNE -- Wall Street's cash printing machine may be finally out of ink. One by one, the big U.S. banks reported dismal quarterly earnings this week, blaming the poor results on everything from the European debt crisis to court settlements.

While tough market conditions did play a role in ruining Wall Street's annual money dance, it was hardly the main reason for its poor performance. The traditional investment banking and lending businesses have been gutted after new regulations forced the banks to decrease risk. Safer investing on behalf of the banks this quarter has translated into a return on shareholder's equity that's more akin to a sleepy regulated utility as opposed to an aggressive investment firm.

So should bank investors get used to such lackluster and weak returns on their capital? While not every firm has the exact same problems, there is a common theme running throughout their earnings. Trading revenues at all major banks were down significantly from the heydays before the credit crisis. As a result, the firms' return on common shareholder equity, or ROE, which measures the efficiency of a company's earnings power, has collapsed.

Let's look at some numbers. Given the lumpiness of bank earnings, it is best to look at full-year results as opposed to quarterly results. Goldman Sachs's (GS) annual ROE came in at a shockingly low 3.7% for 2011, down significantly from 11.9% the previous year. Before the financial crisis hit, Goldman's ROE was an industry-leading 32% in 2007 and 2006. But it wasn't just Goldman who sputtered. Morgan Stanley's (MS) ROE came in at 6% for the year, down from 7% in 2010. Morgan had a 9% ROE in 2007 and averaged an annual 20% ROE from 2000 to 2006. JP Morgan (JPM) fared a bit better with an ROE of 10.2% for the year, up slightly from the 9.7% it hit in 2010. But the firm is still below its pre-crisis ROE of around 13% in 2007.

Star dims for Goldman's youngest partner

All this means nothing unless it is put in context. For the level of risk and amount of capital these firms hold, single digit returns on equity is pretty lousy -- and the banks know it. Goldman promised earlier in the year that it would hit a respectable 20% ROE in 2011. But its executives quietly dropped that goal in May after it became clear that its trading division was having some troubles.

To be sure, ROE isn't the be-all-end-all metric that Wall Street lives by. There are dozens of other performance metrics that banking chieftains target, which are specific to the banking model. Nevertheless, ROE, while it has its flaws, is still a metric that investors and analysts like to see as it flattens out the sector, allowing them to compare it with other asset classes.

There were two major structural changes that took place in the industry in the aftermath of the crisis that shook the trading world. The first was that several of the major players in the space ceased to exist. The second was the string of regulatory changes that forced the banks to cut risk and maintain larger capital buffers. Goldman and Morgan became bank holding companies like rivals JP Morgan and Bank of America (BAC) and were therefore forced to scale back on their risk taking. Higher capital requirements meant less money to use for trading. Lower leverage levels meant lower returns on investments.

Despite the structural changes, the banks still maintain that they will be able to boost their returns on equity back up to double-digits, close to where they were before the crisis. Investors and analysts have been giving the banks the benefit of the doubt, but have since been sorely disappointed. The common view is that the employees at these firms are so smart, innovative and connected that they will find some way to get out of the mess they created, dodge the new regulatory constraints and eventually return to minting money.

But it's now looking as if that will never happen. Sure, the banks will make a profit, but gone are the days where it could make ROE's north of 30%. Stripping out the risky proprietary trading and ancillary investing silos, the banks' broker-dealer and retail banking businesses are pretty low margin.

What's the point of private equity?

For now, the banks are focusing on cutting spending to boost their ROE. They have largely been successful in cutting waste, but there is only so much they can cut without jeopardizing their business models. Going forward, the banks will need to either force their clients to pay more for the services they offer or cut employee compensation dramatically if they are serious about upping their ROE.

Getting customers to pay more for services seems to have been a bust so far on both the brokerage and retail banking ends. Compensation is the one area that the banks have direct control over. While the amount the banks pay their employees has fallen in real terms, it has not budged relative to the firm's overall revenues and in some cases, it's actually gone up. Goldman actually increased its compensation ratio this year to 42% from 39%, even though revenues at the firm were down by 26%.

Not to be upstaged, Morgan Stanley had the highest compensation ratio of the big banks at 51%, which is roughly where it was last year. Meanwhile, JP Morgan's investment bank had a compensation ratio that was significantly lower than that of Goldman or Morgan Stanley at just 34%. That might explain in part why JP Morgan's ROE was higher than that of both Goldman and Morgan Stanley, combined.

This year will be a critical turning point for the banks. They will need more than just a return to normal business conditions to boost their ROE -- they will need to raise fees and cut compensation aggressively. At the same time, investors and analysts need to rethink what it means to be a bank in the 21st century and be more realistic about the industry's ability to make money.

But it isn't all doom and gloom. While the banks probably won't report an ROE above 30% in the near future, they can still post some pretty strong profits if they roll with the times.

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