Who can blame them when banks are performing at their strongest levels in a decade? Industry stock prices have recovered to pre-crisis highs, banks are reporting record profits and favorable Federal Reserve stress test results reflect financial strength and increased shareholder distributions.
Unfortunately, these observers and others may be suffering from risk myopia concerning the industrywide near-death experience that happened just a decade ago. They are also ignoring the cyclical nature of banking, which continues to suffer from too many banks. The financial services industry tends to grow less sensitive to risk as the time from the last crisis increases. Institutional memories fade as more crisis-scarred veterans retire.
There are often warning signs that trouble could be looming— weak loan demand, a flat yield curve and reduced return on equity — but these are often dismissed as temporary aberrations.
Of course, I am not suggesting another crisis is on the horizon. But there still needs to be a recognition that “golden ages” can be delusions. Building a business plan on golden assumptions without a credible downside is fantasy, and bankers should be skeptical of those peddling such plans.
Policymakers and bankers have stumbled over this trend before. Over 20 years ago, former Fed Chairman Paul Volcker wondered how an intensely competitive banking industry could be as profitable as it appeared then. There’s even more competition in the financial services industry today, and so this contradiction is heightened.
There are three leading explanations for the apparent paradox.
Some argue that it reflects the increased market power of banks over their customers, allowing them to earn abnormal returns. This would have by now attracted the attention of government antitrust officials and is unconvincing.
Others note that the current cyclical improvement could be construed as a permanently high plateau. This seems more like overconfidence and wishful thinking. History should have taught us by now that ignoring cycles, extrapolating off recent trends and failing to consider mean reversion never ends well. Current success seduces many into believing it will continue as the new normal, even though this assumption is mistaken.
Finally, and perhaps most persuasively, there is the likelihood that current results reflect a combination of increased risk-taking and luck. This is what happened leading up to the last financial crisis in 2007. Increased competition usually leads to heightened risk-taking to maintain earnings momentum. Thus, current profits may be illusory, with losses materializing in the future. Yet until things take their turn, the best results go to the banks that take the most risk.
The worst loans are made in the best times, and the recent rollback of regulatory constraints will only hasten the process.
It seems the lessons of banking are continually rediscovered. Golden-age predictions are typically raised near a cyclical peak, as the recent drop in bank stocks may reflect.
The four most dangerous words in banking remain “this time is different.”