R. Christopher Whalen
Aug 15, 20229 min
August 15, 2022 | Premium Service | In this issue of The Institutional Risk Analyst we focus on the world of universal banks, institutions that have a depository but are primarily involved in the investment business, including advisory, capital markets and investment banking activities. We exclude the top-four money center banks from this group, but include some of the best performing stocks in the industry, both in terms of operations and also market performance.
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We published a profile on Raymond James Financial (RJF) last November and the company has outperformed much of the bank group since that time, both up and down. Financials generally have rallied in the past month on hopes that inflation will moderate, but we’d point out to our readers that the FOMC won’t start shrinking the Fed’s balance sheet until next month. The advisory income that RJF and other members of the universal bank group generate will enable them to outperform many money center banks in the uncertain and likely volatile period of adjustment ahead. In this report, we feature:
All of the firms above are bank holding companies with large broker dealer subsidiaries, but that is where the similarities end. Goldman Sachs (GS) and Morgan Stanley (MS) are more traditional brokerage and investment management models, married to significant trading and investment banking lines.
Charles Schwab (SCHW) and Raymond James (RJF) are far more focused on the advisory business and building both client assets and related bank deposits than trading or investment banking. SCHW is also a sponsor of money market funds and exchange traded funds (ETFs), as well as offering third-party managers to its advisory clients.
RJF and SF have significant investment banking arms, but these businesses are smaller than the advisory businesses of these firms. Of the two, Stifel Financial (SF) is a more traditional securities firm with substantial principal and investment banking activities, but also boasts almost $400 billion in wealth management assets.
We have written positively about MS in the past because we believe that CEO James Gorman created a goal of building a diversified universal bank and executed on that strategy. Gorman had to pay a significant price to acquire some of the businesses absorbed by MS over the past several years, including E*TRADE (2020), Eaton Vance (2020) and FrontPoint Partners (2006), but there was no real alternative.
Likewise, SCHW, RJF and SF have made significant acquisitions and also paid and today pay top dollar to attract advisors onto their platforms. SCHW acquired TD Ameritrade in an all-stock transaction valued at approximately $26 billion that closed in 2020.
Both RJF and SF have been gradually rolling up brokerage firms and advisory businesses for much of their existence. The 130-year old SF has a storied history of acquiring other brokerage business from its base in St Louis. It became a bank holding company in 2007 when it acquired First Service Financial and now has two national bank units. Many years ago, SF floated a loan for Bolivia.
GS has a large investment management business, and a consumer and wealth arm, and the fees reflect the fierce competition for assets. If we compared $4.4 billion in investment management revenue with $2.495 trillion in assets under supervision, the gross is just 17bp. Throw $7.1 billion in revenue at MS vs $5.6 trillion in assets managed or in wealth advisory accounts, and the result is 12bp. Yet the sheer size of these business allows them to contribute to profits with ~ 10% ROE for MS in recent years from the asset side of the business.
The exception to the rule of growth by acquisitions in the group has been GS, which has refused to make a transformative acquisition of a bank for fear of losing control over the overall business. SCHW, for example, paid to grow into the 7th largest bank in the US by spending money to acquire advisors. We have argued that Key Bank (KEY), with over $100 billion in core deposits and a focus on financing and servicing commercial real estate would be a good fit for GS, but prudential regulators would force the resultant bank holding company into a very different business model than the present-day Goldman Sachs.
Eschewing acquisitions, GS instead has chosen to grow organically, particularly with respect to the banking side of the business and with decidedly mixed results. Below we go through the key indicators that we use for all banking groups, namely credit loss rates, the gross yield on loans and leases, funding costs and finally profitability vs total assets of the parent company, which is how the Federal Reserve Board looks at these companies.
Source: FFIEC
As the chart above suggests, GS is a good bit above its peers in terms of loan losses. We can take comfort from the fact that the GS loan portfolio is relatively small, just $250 billion, but it is now big enough to hurt the firm if credit conditions deteriorate to a degree equal to the benefit lenders received from QE during 2020-2022. Note that the other members of the group including MS and Peer Group 1 are well below the outlier GS. The loan book at GS has grown 140% over the past five years, of note, 5x the growth rate of the firm’s capital.
Next stop is the pricing on the loan book, an important indicator of operational efficiency and management control. Note in the chart below that the gross spread for Peer Group 1 is near 4% while larger banks have seen spreads compressed to 3% during QE. GS is next above 3% gross yield, but the rest of the group are below 3% yield before SG&A. Note the way that GS was forced to give ground on loan pricing during QE in 2020 and 2021.
Source: FFIEC
The question of loan yield is crucial to all of these banks, however, because market interest rates are rising faster than loan yields. GS saw interest income rise 35% over the year ended June 2022, but interest expense rose 56% over the same period. The next key factor after loan yields to consider with this group is funding costs, shown in the chart below as interest expense vs average assets. Note that SCHW had the lowest cost of funds in the industry at just 8bp in Q1 2022, a position unchanged in Q2 2022.
Source: FFIEC
Through the end of Q1 2021, GS had a cost of funds that was 2x the rest of the group and, significantly, above the average for Peer Group 1. MS, on the other hand, has a funding cost that is below the average for the top 134 banks in the US above $10 billion in assets. RJF has a relatively high cost of funds, while SF has a cost of funds below all of the other names in this report other than SCHW.
At the end of Q1 2022, MS had $340 billion in core deposits comprised almost entirely of retail funds from its advisory clients. MS has no jumbo deposits in its liability structure, zero. GS, on the other hand, has a significant proportion of deposits in jumbo CDs, foreign deposits and other forms of “hot” money that can depart immediately. GS had $200 billion in federal funds borrowed at the end of Q1 2022 vs just $74 billion for MS. Total noncore funding at GS was over $700 billion at the end of Q1 2022 vs $321 billion for MS.
Despite the efforts at diversification, MS and GS remain dependent upon investment banking and principal trading for a large portion of profitability. The table below shows the total derivatives positions of the top banks as a percentage of average assets. Note that MS and GS have the largest notional positions in derivatives, literally thousands of percent of total assets, higher than JPMorganChase (JPM) or Citigroup (C). These positions are about 80% interest rate contracts, but are many times the total capital of both firms. The other names in this report have little derivatives exposure and are more focused on third-party business for clients. SCHW, for example, has less than 5% of total assets in gross derivatives positions.
Total Derivatives/Total Assets (%)
Source: FFIEC
The last key indicator to inspect is net income, one of the most important performance benchmarks for any financial institution. More than capital, banks survive because they can generate sufficient earnings to offset credit costs and continue to operate profitably. When a bank has to rely upon capital to offset credit losses, then you can be pretty sure that the Federal Deposit Insurance Company is already marketing the bank for sale. Since the enactment of Dodd-Frank, the FDIC now has the legal authority to place the entire organization into conservatorship and to then sell the enterprise intact without resolving the subsidiary bank.
Source: FFIEC
As the chart above illustrates, the two smallest members of our universal bank group have the best financial returns measured against total assets. RJF and SF, which have both performed well during the recent market downturn and rebound in Q2 2022, also have consistently better financial returns on assets overall. MS did 1.02% ROA in Q1 2022, but RJF and SF were close to 2% or 2x the 1.2 average for Peer Group 1.
Q2 2022 Earnings
The results for most of the universal bank group were weaker in Q2 2022, if for no other reason than the modest selloff in equities reduced assets under management (AUM) across the industry. GS saw results fall sequentially and YOY, but asset management was up almost 100%, an illustration of the volatility that attaches to this particular line item at Goldman. Total net revenues in the first half of 2022 were down 23% vs the previous year, again illustrating the volatility in the GS income statement.
Likewise MS saw weakness in Q2 2022, both sequentially and YOY. Institutional securities took the brunt of the decline, but all three of the main business segments showed weakness due to market conditions. Provisions for credit losses also rose to $101 million in Q2 2022, the highest level seen at MS since 2020. SCHW, by comparison, reported record revenue in Q2 2022, with revenues up 6% for the first half of 2022. SCHW is a far simpler business than either MS or GS and it shows in the fact that the summary of advisor activity takes up the entire financial supplement.
SCHW CEO Walter Bettinger makes clear in his Q2 2022 comments that client engagement, not market conditions, is the chief metric that SCHW uses to measure success. Remember, while SCHW has lower nominal income than its peers, the risk-adjusted returns are far higher. SCHW has total nominal assets of $648 billion for the purpose of the basic regulatory leverage ratio, but the risk weighted assets component for Basel capital purposes is only $154 billion. The bank reported ROE of almost 20% in Q2 2022.
RJF saw revenues and earnings up in Q2 2022, which is Q3 in the bank’s fiscal year for purposes of GAAP reporting. The bank holding company still files quarterly financials on a December year-end for regulatory purposes. Revenues were down slightly on a sequential basis, but up 16% for the past nine-months. Provisions for credit losses were up 66% YOY, reflecting the normalization of credit across the markets. RJF had 8,600 advisors at the end of June 2022 and is aggressively recruiting in the channel.
SF saw revenue and earnings down in Q2 2022, with both commissions and principal transactions under pressure due to market conditions. SF in many ways has more in common with GS than with RJF. We think of RJF as a smaller version of the giant SCHW, which is now the largest platform for RIAs and also a dominant provider of tools and solutions for independent advisors.
SF is a classic investment bank with deep roots in the Midwest community and a fierce devotion to client service. They have literally rolled up dozens of other firms over the past century and, more recently, several banks. The $35 billion bank holding company reported solid results with net revenues of $1.1 billion, the second highest second quarter in its history, driven by higher net interest income and asset management revenues.
Bottom line: We like the universal banks as a group because of the stability of earnings and low risk, but MS and GS are obviously outliers due to the trading and market risk taken by both firms. SCHW is the low-risk player in the universe of US universal banks, serving as the enabler and finance provider for independent advisors. But for us, RJF and SF may offer the most interesting opportunities in the universal space as each firm continues to grow its advisory business and related bank deposit base, but without the outsized market risk taken by GS, MS and the top-four money center banks led by JPM.
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