The U.S. banks recently reported another excellent quarter of earnings, with the recovery in earnings continuing to substantially outpace the recovery in bank stock prices. Although lower than Q1-12’s earnings of $28 bln (owing primarily to a $2.3 bln Q/Q decline in trading), Q2 earnings for the publicly traded banks were still a very meaningful $26 bln. This exceeds earnings levels achieved by the banks before entering the downturn (i.e., ~$25 bln/quarter).

Bank stocks have, however, simply not kept pace. In fact, despite this 100% recovery in earnings (and a significant increase in pre-tax pre-provision earnings since the downturn began), the aggregate market cap for the publicly traded banks remains nearly 30% below its peak (in Q1-07). Moreover, balance sheets are much stronger, with reserves and capital at extremely high levels. “Bad loans”, while still elevated, continue to decline.

Attractive yield

The main negative for the U.S. banks today is that the system simply has too much capital. Built during the credit crisis through capital raises and dividend cuts, tangible common equity is now a gigantic $840 bln. That’s up nearly 100% from $428 bln before the crisis began (Q4-07). Although the system is currently generating a ~12% ROTE and ~9% ROE (and we expect both to normalize in the low teens), the sector remains a story of “haves” and “have nots”. The latter group consists of literally hundreds of banks that lack the scale to generate a 10%+ ROE. As a result, they will likely sell. We believe this is yet another factor that will help fuel a large round of M&A in the coming quarters/years, as the system aims to remove excess capacity and improve returns.

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