Why Wall Street profits do not reflect Main Street health

Earnings season is underway. True to form, the biggest names on Wall Street started things off yesterday. JP Morgan, Goldman Sachs, Citi and Wells Fargo all released their quarterly updates, delivering what can best be described as a mixed outcome.

Goldman Sachs and Citi managed to beat expectations on earnings. JP Morgan, however, missed its mark in an uncommon way. As for Wells Fargo, revenue failed to match forecasts, even though its profit numbers came in above what was expected.

Even so, the discussion revolves around some of the largest financial institutions globally. They keep churning out billions in profits every quarter regardless of these misses. This surely reflects a fairly healthy US economy, right? The answer is not so straightforward.

The fact that large lenders generate huge profits does not automatically imply that the broader economy is in equally robust health. To fully grasp this idea, it helps to examine where banks derive their income.

Imagine a simplified scenario where I act as the bank. Customers deposit funds with me, and I pay them an interest rate. I then loan those funds out to other borrowers at a higher rate. If I hand over a 2% return to depositors and take 7% from borrowers, the resulting 5% spread exists before other expenses are deducted. Not a bad setup.

This model forms the bedrock of bank lending profit. Elevated interest rate environments can actually boost this income, provided the cost of acquiring funds increases at a slower pace. JP Morgan serves as a good case. The bank had an earnings disappointment overall but still brought in roughly $27 billion in net interest income, an increase of almost 13% compared to the year before.

There is a drawback, however. The very high borrowing costs that boost bank earnings simultaneously put pressure on their customers.

A family weighing up a mortgage or a small firm planning an expansion might simply postpone their decisions once financing gets too costly. The direct consequence is a reduction in fresh lending now, which can diminish interest income for banks later.

Additionally, there is the danger that current borrowers may have difficulty servicing their debt. Evidence of this concern is already visible. Wells Fargo, for example, allocated roughly $1 billion for prospective credit losses last quarter, a rise from $681 million in the same period the year before. This is not proof of an immediate surge in defaults, but it is worth monitoring.

To be sure, overall loan portfolios are broadly expanding and credit quality indicators remain fairly steady. It is also worth noting that large banks derive considerable revenue from trading and investment banking, not exclusively lending. This very point highlights why stellar bank profits should not be mistaken for universal economic strength.

While a bank may see higher earnings from current elevated interest rates, these identical costs can push households to tighten their belts and businesses to postpone growth projects. Should these strains intensify over time, lenders could face the repercussions in the form of weaker demand for loans and a higher incidence of debt repayment difficulties.

The key takeaway is that robust earnings figures reveal how financial institutions are performing, but they do not automatically provide an accurate gauge of the broader economy's resilience.