So, bill signed; game on.  With statutory protection from add-on regulatory requirements, BHCs between $50 billion and $250 billion – and maybe even more – are about to click on the “ready to check out” button to buy a bank or two.  Is this shopping spree a sign of undue profitability, as critics will surely allege?  On the contrary, banks generally buy other banks because they’ve run out of cost-cutting or, even worse, revenue-enhancing options to boost profitability.  The consolidation scramble should be seen for what it really is:  the only way to make mid-sized BHCs more than modestly profitable as long as rates are low, the economy is torpid, and the rules are still about the same.

I know what you’re thinking:  banks are in fact wildly profitable – the FDIC said so on Tuesday.  Actually, it didn’t say so – what it showed was a record dollar amount of average industry profitability.  Viewing bank profitability as record profitability by dollar totals is a lot like saying that Venezuelan bakers are raking in record bread prices.  Inflation makes a difference – a lot of difference. 

Size also makes a lot of difference.  A $100 million profit for Federal Financial Analytics would indeed be record breaking.  For JPMorgan, $100 million is pocket change.  Dollar revenue totals are up because banks are bigger.  Maybe banks shouldn’t be bigger, but they are.  And, even if banks weren’t bigger, the economy is when measured by nominal GDP.  Bank lending has in fact shrunk in comparison with private-sector GDP.  Dollars notwithstanding, the basic business model of banking is far from robust.

Investors know this.  They measure profitability not by dollar totals, but by return on assets (ROA) and – even more importantly- by return on equity (ROE).  Even with the windfall the tax law threw their way, insured-depository ROEs last quarter averaged 11.4 percent.  Translation: even with all the tax loot, the industry is just barely breaking even given the benchmark cost of capital of about ten percent.  Record ROE was in 2003 – well before the crisis boom – when it hit fifteen percent according to the FDIC and thus provided a tidy ROE given the cost of capital.

Advocates of higher capital requirements expected that the cost of capital would go down as capital standards rose.  The reason for this comes from classical economic theory (Modigliani-Miller) which found decades ago that investors demand less when risks drops.  This might be true, but it hasn’t worked for banks, as a comprehensive survey of post-crisis capital rules from the Bank for International Settlements concluded.

Which brings me back to why even a bit of regulatory relief will spark a consolidation wave.  Lower regulatory costs boost earnings even in the absence of a revenue-enhancing business model.  With the rollback of size thresholds that added new costs for no good reason, banks can buy another bank, shed some costs, increase efficiency (or at least so the theory goes), and voila – shareholder value.  Cost savings in M&A transactions are always possible over time, but near-term regulatory relief boosts these savings and thus gives M&A an added shareholder rationale. 

Does this rationale hold quarter over quarter as two banks are finally combined into the bigger one from which costs savings are supposed to come?  Eliminating an add-on regulatory cost increases efficiency, but the real value in a bank charter is its revenue-enhancing products, not a skinny infrastructure that might undermine customer service and increase operational risk.  Even before the crisis rules kicked in, the real shareholder-value proposition in monster M&A transactions was validated only sporadically in the best-constructed transactions.  With many rules untouched by the new law and a whole lot of unregulated competition, M&A remains a short-term solution to the longer-term questions surrounding the future of traditional financial intermediation through regulated banks.