In the steamy days of July 2018, bank earnings are more interesting than usual, in part because our beloved friends and colleagues in the financial world continue to intone the false mantra that rising interest rates are good for banks.

First off, it is not true that rising rate rates are always good for banks. Increased interest rates, for example, have not helped Goldman Sachs in the past few quarters.

“Banks make money on the spread, that’s it. That’s the story,” said our friend Josh Brown, CEO of Ritholtz Wealth Management, on “CNBC’s Fast Money” this week. At the time, Brown was surrounded by a bunch of earnings-happy pundits singing the praises of higher short-term interest rates for bank earnings.

He was right. Banks make money on widening spreads, not because of a quarter-point move in Fed funds.

Spreads, of course, are not really widening as the Federal Open Market Committee pushes up short-term rates. After moving up about 75 basis points over the past year, non-investment-grade spreads started to fall after the most recent FOMC rate hike in June.

Indeed, the 10-year Treasury has declined about 30 basis points in yield over the past month, reflecting the continued tightness of credit spreads — at least for some issuers.

Second, look at the earnings themselves. The second-quarter bank results released so far confirms the accelerating upward trend in bank funding costs.

Christopher Whalen

As we detail in the most recent, Q2 edition of The IRA Bank Book, the rate of increase in funding expense for all U.S. banks should exceed the rate of growth in interest earnings by Q2 2019. That means net interest margin (NIM) will be shrinking. It’s an eventuality that most market analysts and institutional wealth managers really are not prepared to accept — much less reflect in asset allocations.

In our projection for aggregate funding costs, we hold the growth rate in total interest income steady at 8% through the end of next year. That’s an admittedly generous assumption given the way the FOMC has capped asset returns via quantitative easing.

On the other hand, we limit the annualized rate of increase in funding costs to “only” 65%, a rate of change already more than reflected in the rising funding costs of names like First Republic Bank (FRC) and Bank of the Ozarks.

Most of the largest U.S. banks that reported earnings this week saw interest expense rise by mid-double digits, even as interest earnings rose by single digits.

Goldman Sachs, for example, saw its year-over-year funding expenses increase 61% in Q2 2018, while interest income rose just 50%. Citigroup, on the other hand, being already positioned in the world of institutional funding, saw interest expense rise only 28%. But the Q2 2018 earnings seem to confirm a rising trend in funding costs that could see NIM flatten out and decline by 2019.

When David Solomon ascended this week to the CEO chair at Goldman Sachs, our friend Bill Cohan commented on CNBC that this amounted to a takeover of Goldman by alumni of Bear, Stearns & Co., where Solomon and I worked together many years ago.

Cohan also reminded Andrew Sorkin et al. on “Squawk Box” that the freewheeling Goldman of old is long gone and that the firm is now run and regulated as “a bank.”

Well no, not really.

Goldman Sachs is basically a broker-dealer with a small bank in tow. When you compare its Q1 2018 net interest margin with those of the other members of Peer Group 1 (defined by the Federal Financial Institutions Examination Council), the latter reported NIM of 3.28%., vs 0.41% for Goldman.

Because Goldman’s bank unit is so small, the overall NIM for the group is one-10th that of its peers compared with total assets. Goldman makes less than 2% on earning assets, vs. almost 4% for its asset peers. So to paraphrase the wisdom of Josh Brown, Goldman does not make money on interest rates, up or down, but rather earns fees from trading and investment banking. It profits from the spread, in terms of both price and volume.

The basic problem confronting David Solomon and his colleagues is that Goldman really is not a bank. It’s regulated like a bank and therefore constrained in its business activities, but it does not earn the carry on assets that most banks take for granted when they turn on the lights each morning.

Talk of expanding the banking side of the business (aka “Marcus”) is fine, but progress in this regard is very slow indeed. Of the $9.4 billion in net revenues reported in Q2 2018, just $1 billion represented net interest earnings.

The gross yield on Goldman’s loan book (5.24%) is superior to those of its larger peers (4.68%), but the numbers are so small that they’re not really significant in the overall picture. The total return on earning assets for Goldman, 1.85%, is less than half of the 3.94% earned by its larger peers.

Why the poor performance? Because Goldman pays up for non-deposit funding compared to its larger peers. Because it has such a small deposit base, Goldman’s total cost of funds (2.45%) is more than twice  that of its larger bank peers (0.97%) at the end of Q1 2018.

Organically growing Goldman into a true commercial bank will take time and a lot of work, and it’s an outcome that Solomon et al. may or may not be able to accomplish.

Building a bank starts first and foremost with stable funding in the form of customer deposits, particularly commercial deposits from small and mid-size businesses. But with the intensifying competition for bank funding now very visible in the money markets as the FOMC shrinks reserves, don’t hold your breath waiting for Goldman Sachs to transform itself into a traditional depository.

Such a transfiguration is possible, but not very likely in today’s markets. Thus the question for David Solomon and his colleagues: Do you really want to be a bank? Really?

Christopher Whalen is chairman of Whalen Global Advisors, a provider of investment banking and consulting services to institutional investors and corporate clients worldwide. This article was initially published in Whalen’s online publication, The Institutional Risk Analyst. It is reprinted here with Whalen’s permission.

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