When Morgan Stanley yesterday announced its E*Trade acquisition, the deal was denounced by some as a dangerous GSIB expedition into risks once barred by post-crisis rules. Unmentioned is a far more important point hiding in clear sight in Morgan Stanley’s own announcement: without this deal or something like it, this GSIB and most big banks face a high-risk future far different than their pre-crisis failings. They are now caught in an inexorable combination of ultra-low rates, slow macroeconomic growth, increasing inequality, devastating competition from unregulated powerhouses, and collapsing retail-delivery costs countered only with increased expenditures made unprofitable by post-crisis rules. Redesigning charters for as much profit as possible, GSIBs put financial intermediation for low- and moderate-income and middle-class customers in the rear-view mirror. Finding profit where they can, GSIBs will double-down on Morgan Stanley’s focus on fee-based revenue unless policy quickly reckons with the new, merciless competitive reality.
Yes, I know – GSIBs are seemingly raking in “record profits.” However, looking at earnings the way investors – not politicians – do tells a different story. Analysis below top-line, nominal dollar totals shows that most banks and especially most GSIBs and particularly Morgan Stanley are struggling for profitability. Return on equity (ROE) is the most critical investor profit criterion and ROE for FDIC-insured institutions has hovered around 9.6 percent since 2011. In terms of return on common tangible equity, large-bank profitability is still well below long-term averages even with a boost from Uncle Sam. The 2017 federal tax cut contributed somewhere between ten and twenty percent to earnings at more than half of the largest U.S. banks after the law went into effect which “masked disappointments in business lines at many institutions.” Tax cuts continued to support profitability through 2019, adding $32 billion to big-bank totals according to Bloomberg. Even with these boosts, capital costs banks about ten percent, meaning that banks with ROEs below ten percent run at a likely loss unless they can convert their models to less capital-intensive operations. E*Trade’s commission and fee model is thus an ideal way out of the profit abyss.
No wonder then that analysts are upbeat on the E*Trade deal no matter the political risk. Bank investors need to keep hope alive, leading most of the market commentary on Morgan Stanley’s E*Trade transaction to tout its long-term potential to enhance durable earnings, moving the company into the “mass-affluent” market offering fee – not spread-derived financial-intermediation – based earnings. Morgan Stanley’s own objectives for this merger make clear that it shares these market expectations, describing the transaction as one accelerating its transformation into a business profiting from a “balance sheet light business mix,” not from the spread between cost of funds and return on assets – i.e., not from financial intermediation.
This will or won’t work for the company’s purposes – many big deals have foundered due to unanticipated operational complexity, hidden risks, and economic downdrafts. But, no matter Morgan Stanley’s future in discount brokerage, the transaction accelerates not only its business-mix transformation, but also the exodus of the largest U.S. banks from equality-essential financial services.
Although Morgan Stanley’s new business moves it from white shoes to Chuck Taylors as one analyst noted, these are Chuckies worn for style, not need. Zero-commission trading combined with fractional-share options does provide an entry for lower-wealth households into the equity markets, an urgent need given how radically ultra-low rates have eradicated the wealth benefit of a traditional savings account. However, stock trading, especially day-trading, is not for more than a few of the masses. The bulk of household stock ownership – 86.5 percent – is in the hands of the wealthiest ten percent of households, and the top one percent owns more than half of all U.S. stock. The bulk of E*Trade’s earnings in a zero-commission world come from the spread on deposits backing margin loans and custody services, businesses that may reduce Morgan Stanley’s funding costs and increase its custody competitiveness but that will not offer a single new start-up small-business loan or entry-level mortgage outside GSE underwriting parameters.
Let me be clear, I don’t blame Morgan Stanley for rebalancing its business mix to make itself more of an investment bank for a few more Americans. Like all GSIBs and most banks, Morgan Stanley’s is a for-profit enterprise and it thus must profit its investors or investors will take a powder. If they do, then financial-market peril will follow. As Larry Summers observed in an in-depth study a few years ago, profitability is essential to financial stability. This is also a lesson now being learned the very hard way in the European Union, where years of half-hearted reforms combined with negative rates and weak growth have created structural risks that could easily turn systemic.
The Fed should or shouldn’t approve the E*Trade deal on its merits, but the simple fact that a GSIB is going for something new should not on its own doom the deal. GSIB opponents discount at great peril an acute risk: a fast-shrinking regulated banking system with little resilience and less capacity to support equitable growth.