JP Morgan's 12 is a lonely number

Something remarkable happened Friday in the banking sector. No, it wasn't JP Morgan Chase and Wells Fargo kicking off the third quarter earnings season by touting record profits. Or JP Morgan boss James Dimon declaring the US housing market "has turned the corner."

The wondrous event took place deep in JP. Morgan's financial statements. Sandwiched between long numbers telling the story of the bank's gargantuan size, sits a small "12," closely followed by a percentage sign. To its left, the words: "Return on common equity (ROE)."

There, in a statistical nutshell, lies the predicament facing banks around the world: they aren't earning enough to justify their existence.

Twelve is something of a magic number because banks have to earn more on their capital than they pay for it. With capital costing somewhere between 8% and 12%, executives and analysts believe that a lender has to earn an ROE of around 12% to be a worthwhile investment.

JP Morgan managed to hit that mark for the July to September period by riding the US boom in mortgage refinancings and a strong showing by its investment bank, among other things.

If that sounds routine, think again. The world's largest 300 lenders earned, on average, a measly ROE of 7.6% last year, according to a recent study by McKinsey & Co.

And that is only because lenders in emerging markets had oversized returns. Banks in Europe, with a chilling 0%, and the US, with an insufficient 7%, were nowhere near covering their cost of capital.

Even JP Morgan, one of the soundest banks in the world, has managed to reach 12% or more in only four of the 19 quarters since the beginning of 2008.

By contrast, before the financial crisis banks' ROE often exceeded 15%, driven by benign markets, strong economies and lenders' appetite for high-risk, high-reward trading strategies.

The reasons for the current sluggish performance are well-known and reflected in banks' valuations: macroeconomic shocks, tighter regulations and unforgiving markets have crimped activity, forced lenders to set aside more capital and reduced the debt they can take on to turbocharge profits.

Optimists have hailed JP Morgan's results as the start of the sector's long-awaited recovery amid a healing US economy and calmer markets. Investors seem to agree and have propelled US banking stocks to a mini-rally in recent months.

I wouldn't be so sure.

Banks have been extraordinarily slow at adapting to the harsher business climate. Take cost cutting. Lenders have talked a good game, but their overall cost base hasn't budged. Last year, banks' expenses totaled $2.5 trillion globally - $200bn more than before the crisis, McKinsey found.

Financial groups did shed hundreds of thousands of jobs, but the layoffs merely tracked the fall in earnings. The industry's costs have been stuck at around 60% of its income since 2007.

Short of a sharp economic recovery or more draconian expense cuts, profits will be hard to come by. McKinsey estimates that cost to income ratios in the US will have to fall to 51% from the current 68% for banks to earn a decent ROE. In troubled Europe, the culling will have to be even more dramatic.

Few believe those feats can be achieved in the short term. Of the "Big Six" US banks - Wells, JP Morgan, Citigroup, Morgan Stanley, Bank of America and Goldman Sachs - only the first one is expected by analysts to clear the 12% ROE hurdle in 2012 and 2013.

So why aren't more banks failing, merging or shrinking into insignificance?

Ask Uncle Sam and his European cousins. Since the crisis, Western governments have pumped some $1.7 trillion into banks through capital injections, cheap loans and asset purchases, according to the International Monetary Fund.

That liquidity postponed the day of reckoning, encouraging slower cost cutting and saving weak players from failure or mergers with healthier rivals.

Some banks are using the time bought by taxpayers' generosity to transform themselves through information technology.

Many executives I meet pin their hopes for a quick turnaround on a "technological revolution" in the likes of bond trading and mobile banking. In their view, improved IT will cut costs (i.e. salaried humans) and bridge the vast gap between what banks offer and what customers expect, boosting profit margins.

Unfortunately, this process, akin to the industrialisation of the manufacturing sector decades ago, won't be fast or cheap. Just think of the massive investments required to overhaul the IT of global banks whose activities range from checking accounts to derivatives trading. Until it is completed, every dollar in profit will be a hard won victory.

Next time a bank executive extols "record" results, investors shouldn't rejoice until they have checked whether "ROE" and "12" coexist on the same line.