JPMorgan Chase’s impressive quarter wasn’t that impressive after all

JPMorgan Chase's impressive quarter wasn't that impressive after all

Last Friday, JPMorgan Chase (JPM) reported its 2016 fourth quarter results. The company smashed the expectations of stock analysts. Let’s take a quick look at what actually happened.

You should look at these two charts, then tell me what the story line is

Before I diagnose anything, I want you to look at two charts. One shows JPMorgan Chase’s quarterly revenue for the past five quarters. The other shows quarterly net income for the same period. Both data sets are broken down by JPM’s business segments.

Here’s what I want you to do. Look at these two charts, and guess what the story line is. All you know is that investors are happy with JPMorgan Chase’s most recent quarter.

JPMorgan Chase revenue by segment, 2015 Q4 through 2016 Q4

JPMorgan Chase, net income by segment, 2015 Q4 through 2016 Q4

In the interest of being precise, I should note that all amounts are in millions. But again, before we proceed, what do you think the story was?

You finished?

If you guessed the story was the profitability of the Corporate & Investment Bank segment…you’re wrong! (Though that’s what I would have chosen.) 

Here’s CNBC’s headline: “Money in the bank: Booming consumer business pushes JPMorgan past Street forecasts”. You see the Consumer numbers above? They look okay. Revenue declined for the second consecutive quarter, and was below its year-ago quarter. But net income had a nice jump. So, again, the numbers are okay.

But they pale in comparison to what’s happening with the Corporate & Investment Bank. Revenue declined sequentially, but it’s higher than the year-ago quarter. And profitability skyrocketed sequentially, jumping 18% against an 11% decline in revenue.

First, any double digit jump in profitability for a bank is impressive. Second, it’s even more impressive against a backdrop of declining revenue (assuming the revenue is expected to continue growing in the future).

To be fair, the Associated Press did lead its reporting with the Corporate & Investment Bank performance:

JPMorgan Chase & Co. said its fourth quarter profit rose 24 percent from a year earlier, helped by higher interest rates and strong results from its trading operations.

Still, this episode is a good lesson in why you can’t just skim the business literature and get the whole picture. The numbers clearly point in one direction, but if you read the CNBC piece, you’d think the Consumer segment led the charge.

A short note on how banks report revenue and net income

Before we go further, let’s cover a quirk in how banks report their financial performance. You can divide a bank’s revenue stream into two parts:

  1. Interest income
  2. Non-interest revenue

Interest “income” is a misnomer. It’s actually interest revenue. But JPMorgan Chase insists on calling it interest income. It’s the money that JPMorgan Chase generates from its interest-bearing assets. For example, JPMorgan Chase issues a loan to a client. The client pays interest on the loan. These interest payments show up as “interest income” on JPMorgan Chase’s financial statements.

At the same time, JPMorgan Chase owes interest to other parties. It has its own debt for which it makes interest payments. It has to pay interest on deposits that some customers leave with the bank. JPMorgan Chase then nets it “interest income” against its total interest expenses. It calls the result “net interest income”.

Non-interest revenue is what JPMorgan Chase generates mostly through the fees it charges. For example, JPMorgan Chase might consult with a large corporation about how to structure a bid to acquire another large company. The consulting fees would show up as “non-interest revenue”.

When looking at the bank’s income statement, you’ll then see a unique structure:

  1. Non-interest revenue
  2. Plus net interest income
  3. Minus non-interest expenses
  4. Equals Net income

Keep this distinction in mind. Even though we show “interest income” as part of revenue, it’s actually the the net effect of interest, i.e. incoming interest payments minus outgoing interest payments.

What is Corporate & Investment Banking?

If you want more detail about how JPMorgan Chase makes money, I wrote a post on exactly that topic. But briefly, here are the activities JPMorgan Chase includes in its Corporate & Investment Banking segment:

  • Advising clients on corporate strategy and structure
  • Helping clients raise capital, either through equity (selling part of the company or issuing new stock) or debt
  • Using derivatives and other instruments to manage financial risks for clients and for JPMorgan Chase itself
  • Managing the client’s cash and short-term investments

You can see why it’s called Corporate & Investment Banking. The services are focused on corporate clients. And many of the services revolve around managing various investments.

So which of these activities are most important to JPMorgan Chase? The pie chart below shows how this segment’s revenue breaks down across different activity types.

JPMorgan Chase Corporate and Investment Banking revenue breakdown, 2016 Q4

The biggest part of the pie is for net interest income, which makes up 34% of the total. Again, that’s the difference between all the interest that is owed to JPMorgan Chase and all the interest the bank owes to others. And in this case, the interest we’re talking about is specific to activities in the Corporate & Investment Banking segment. (For instance, it does not include what the bank owes to consumers with interest-bearing savings accounts. This segment focuses on corporate clients.)

The next biggest part is principal transactions at 28%. This is where JPMorgan Chase buys and sells derivatives and other instruments, both to help clients mitigate risks, and to make sure the bank itself isn’t unnecessarily exposed. These are the trading operations of the bank. For what it’s worth, this is where banks got into huge trouble leading up to the financial crisis. 

The third biggest part is investment banking fees. These are the fees that JPMorgan Chase charge customers for consulting, and for helping them issue stock to the public markets, and for helping them draft credit agreements to bring on more debt. 

It’s interesting that these fees are “only” the third largest revenue stream in this segment. When you think of Corporate & Investment Banking, you really need to think about financial instruments. Some of these instruments generate interest income for the bank. Some of these instruments may become more valuable over time, depending on what’s happening in the market. 

JPMorgan Chase’s financial performance depends a great deal on the attractiveness of the instruments it buys and sells to mitigate all kinds of risk: interest rate risk, credit risk, foreign exchange risk, commodity risk, etc. That’s an element unique to the world’s largest banks.

Where did the big performance jump come from?

The very first bar chart in this post showed that JPMorgan Chase actually saw quarter-on-quarter revenue declines in its two largest segments: Consumer & Community Banking, and Corporate & Investment Banking. So how did its performance improve so dramatically?

We see three answers:

  1. A drop in compensation expense by $817 million
  2. A drop in income tax expense by $486 million
  3. A drop in the provision for credit losses by $265 million

That’s how the bank was able to overcome a revenue decline of $994 million. 

(The provision for credit losses is a way for the bank to estimate the revenue it won’t collect because clients won’t pay all that they owe. A drop in that number means the bank is more confident about collecting what it’s owed this quarter than it was in the previous quarter.)

Investors pay attention to one number more than any other: EPS, or earnings per share. If you assume the number of outstanding shares stays the same, then more earnings means a higher EPS.

You can increase EPS in two ways: (1) grow revenue faster than costs, or (2) cut costs faster that revenue falls. The second scenario is what happened to JPMorgan Chase. Revenue fell, but costs fell more quickly.

A similar story unfolded on a smaller scale in its largest segment, Consumer & Community Banking. Revenue fell a bit, but costs fell a little more quickly. 

Cost-cutting isn’t as exciting as growth

Don’t get me wrong. It’s nice that JPMorgan Chase cut costs. It’s nice that it reduced its credit risk, and that it cut its compensation costs. It’s nice that it has a smaller income tax liability. That’s solid operational execution.

But it all happened on the backdrop of an eroding revenue stream. It’s not a scary erosion, but it’s a decline nonetheless. A really exciting quarter would be if the bank found a way to reach new customers, or if it offered more value to its existing customers.

That’s not what happened here. Any revenue gains were offset by revenue losses elsewhere. Leadership made sure costs eroded more quickly, which makes investors feel good. It’s the worst when revenue slips, and management can’t find extra costs to pull out. So the quarter was positive in that sense.

But it’s not like banking is back. Executives and investors are probably excited about the Fed’s upcoming interest rate hikes. That should give the bank more of a cushion than it has had since the financial crisis. Still, it’ll be a long, slow ride to better profitability. And that’s if you believe better profitability is in store. 

(I don’t. I’m not a big fan of banks as investments. I think their financial performance is too opaque. The financial crisis showed just how badly banks can misunderstand the risks they and their clients face. I’m too concerned about future blowups, and the need for further government intervention, to get excited about banks. For one reason why, see how serious the Minneapolis Fed is about breaking up these big banks, with JPMorgan Chase sitting right in the crosshairs.)

What’s the takeaway for those of us who don’t work at a bank?

I write about banks for two reasons:

  1. They’re the focal point of the global economy. And they’re the epicenter of government intervention in the economy. If you’re going to understand economics and finance, you need a working knowledge of corporate banking.
  2. If you understand how banks work, you can better understand how large corporations work. Big businesses live and die by debt and equity markets. Banks are the gateway to those markets. 

Just a passing familiarity with how these big banks work will help you understand so much of the dialogue around finance and the economy. It can sound like a completely different universe, but when you distill it, it’s straight forward.

It’ll help you participate in productive conversations at work. You’ll better understand why the executive team makes certain decisions. You’ll have a better feeling for who knows what they’re talking about, and who’s just blowing smoke. Getting a better read on people is very helpful when navigating a delicate career trajectory.

You don’t have to be a banking expert, but I recommend you know the basics. Don’t take what’s written at CNBC or Bloomberg as gospel. A few times each year, go straight to the source material (e.g. the SEC website). Read through some company filings. Check out the data for yourself. Your all-around business acumen will improve dramatically.

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