Traders at the top Wall Street firms racked up nearly $80 billion of revenue last year. But understanding how they produced all that money is far from simple.
The financial crisis revealed the dangers of banks having murky balance sheets. And some investors think banks’ disclosures are still inadequate. “The major financial institutions in the U.S. and around the globe are utterly opaque,” Paul Singer, the founder of a large hedge fund called Elliott Management, said last year.
At a conference this week, Mr. Singer clashed with Jamie Dimon, chief executive of JPMorgan Chase, over the subject of bank transparency. In the exchange, Mr. Dimon said hedge funds were hardly transparent and added that JPMorgan’s annual report was 400 pages long.
Trading results are good place to start when assessing whether banks release sufficient information.
At large banks, sales and trading is a major source of revenue, often dwarfing the fees that they earn from arranging deals or managing other people’s money. For instance, Goldman Sachs had sales and trading revenue of $18 billion last year, compared with $5 billion from activities like advising on mergers and handling initial public offerings.
Shareholders benefit from good disclosures because they can better assess what value to place on a bank’s business. Trading revenue is not only large – it can also be extremely volatile, bolstering profits one quarter, then hurting them the next. With the right data, investors can do a better job of identifying what drives revenue up and down.
Another dynamic effects trading these days: regulation. Revenue from trading could decline as new rules stamp out certain types of bets. Tougher capital rules could also make the trading that is allowed more costly for the banks.
When it comes to sales and trading, Wall Street firms have differing levels of disclosure.
Bank of America’s investment bank, which contains some Merrill Lynch operations, arguably has the clearest breakdown of what goes into its trading revenue.
Like all big Wall Street firms, Bank of America says that the vast majority of its trading relates to servicing clients who want to trade in and out of stocks, bonds and derivatives. To facilitate the activity, banks keep such financial assets on their balance sheets to meet customer orders.
Each quarter, Bank of America provides the main contributors to trading revenue in a reasonably easy-to-read format.
The most recent disclosure shows Bank of America’s traders booked revenue of $11.8 billion in 2012. Of that, $3.3 billion came from net interest income, which is the interest and other income earned on the securities that Bank of America holds for market-making, minus the bank’s cost of financing those positions. The revenue also included $1.8 billion from commissions and fees.
The largest contributor in this area is called “trading,” which was responsible for $5.7 billion of revenue last year. For the sake of clarity and consistency, it makes sense to relabel this type of revenue “market-making.” That’s because it mainly represents the gain Bank of America makes when it buys securities and sells them on to clients at a higher price.
It also includes any gains or losses that occur when the bank marks up or reduces the value of the trading assets that it holds on its balance sheet. For instance, when mortgage-backed bonds rallied in the second half of 2012, banks holding such bonds would have booked nice profits as the market price of those bonds went up.
As clear as Bank of America’s disclosures are, it would be helpful to get more details, like which type of securities or derivatives provided the bulk of market-making revenue in any given quarter.
Morgan Stanley and Goldman Sachs appear to come second in the disclosure stakes.
With some minor number crunching, it’s possible to roughly create a Bank of America-style presentation for both firms that show the three main components of sales and trading revenue. And something stands out about Morgan Stanley.
The interest income component of sales and trading is negative at Morgan Stanley. It was minus $1.79 billion last year. That suggests it costs the bank more to finance its trading business than the interest it earns on the securities and derivatives it holds for trading. Goldman Sachs, however, showed positive net interest income last year.
One interpretation is that Morgan Stanley, which has a lower credit rating, has to pay more to finance its positions, putting it at an economic and competitive disadvantage. But the negative number may also be because Morgan Stanley holds fewer higher-yielding assets, and therefore earns less interest than others.
At JPMorgan and Citigroup, disclosures are too generalized to clearly see what the three main contributors are to sales and trading revenue. This makes it far harder for outsiders to judge whether market-making is driving revenue gains, or commissions, or higher interest income.
Expect the opacity debate to continue.
