The second quarter earnings release of some of the biggest banking firms in the US surprised investors, with reported revenues and net income beating expectations.

A liquidity boost from the Federal Reserve, as well as strong demand by investors looking for higher yields and hedging against risk, increased income of major financial institutions with significant activity in capital markets.

A surge in income from trading activities did not only boost income of investment banking firms such as Goldman Sachs and Morgan Stanley, but also helped JPMorgan Chase, Bank of America and Citigroup to offset losses from large credit provisions in their core retail banking activities.

However, this favorable condition is not expected to be long-lasting, while investment banking cannot be a permanent safety net for retail banks, especially under adverse macroeconomic conditions.

Federal Reserve’s fiscal stimulus and investors’ strong demand fueled investment banking income

The fiscal stimulus program of the Federal Reserve has boosted activity in capital markets by increasing liquidity through the massive purchase of government and corporate bonds and by slashing interest rates to zero.

Increased money supply at lower interest rates have spurred trading activity, with a strong growth of bond and stock issuance facilitating demand. In fact, trading activity was enhanced by the debt and stock issuance of high-risk corporations desperate to raise funds, as investors have resorted to riskier positions in the stock and bond market in search of higher yields. Meanwhile, investors have also sought to hedge against losses in stocks and commodities like oil, with demand for derivatives such as futures and options contracts boosted as well.

JPMorgan, Bank of America and Citigroup offset losses thanks to investment banking activities

JP Morgan, managed to offset losses in consumer and commercial lending activities, thanks to strong gains from its investment banking and trading activities, where its revenues surged by 91% and 79%, year-on-year. Overall, its total revenue was up by 15% year-on-year, offsetting a 51% decline in net income caused by an eight-fold increase in provisions for credit losses.

Bank of America and Citigroup also witnessed a surge in trading revenues, offsetting losses in consumer and commercial lending activities as well, although their performance was less impressive, having weaker capital market activity than JPMorgan.

On the contrary, Wells Fargo, as a traditional retail bank with high focus on consumer and corporate lending, reported steeper losses from credit provisions. The bank reported a USD2.4bn loss in Q2 – its first quarterly loss since the financial crisis of 2008.

Wall Street banks perform better than their retail-focused peers

Investment banks like Goldman Sachs and Morgan Stanley, which had been struggling from weaker trading activities in recent years, have now benefitted from the current economic turbulence. Goldman Sachs and Morgan Stanley witnessed annual increase of 41% and 31% in revenues in Q2; the resurgence of trading activity boosted their lucrative commission fees on underwriting for their clients, while their trading revenues from bonds and equities were nearly doubled.

Meanwhile, their lower exposure to lending activities and consumer banking has actually turned to an advantage, as their credit provisions are significantly lower than those of retail banks. In fact, Goldman Sachs maintained its profitability flat in Q2 compared to a year earlier, while Morgan Stanley reported a net income increase of 45%.

Investment banking cannot be a safety net

Banks’ profits are expected to take a bigger hit by the end of the year, as credit provision for non-performing loans are set to increase, while trading revenue is set to weaken after the overheated activity in previous months.

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Accordingly, investment banking income can only be a temporary safety net. Instead of relying on that income, banks would have to ensure that money supply ends up in the real sectors of the economy that can bring recovery.

Moreover, an ultra-low interest rate environment that sustains these market conditions remains risky for banking business. As the net interest income from core retail banking activities is eroded, banks would be prompted to intensify investment banking activities, likely increasing systemic risks.

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