Cost-Cutting Paradox Plagues Big Banks

Offering guidance on expenses may keep banks disciplined (and shareholders happy), but the world just has a way of happening sometimes.

Cost control has been top of mind for bankers in the last few years, as they attempt to cut spending without hurting the overall franchise. The hope is for positive operating leverage, where revenue growth outpaces any escalation in expenses.

Several factors have complicated such pursuits, however. Settlements and legal fees are a prime example, adding to the expense burdens at the three megabanks that reported quarterly results Tuesday: JPMorgan Chase, Citigroup and Wells Fargo. Citi also reiterated that it is having to spend money in the short term to make fixes for the long term.

And, as JPMorgan executives argued, sometimes businesses have to spend money to make money. JPMorgan's corporate and investment bank performed better than expected and the unit's employees earned more compensation as a result. The company's 2014 expenses could be higher than planned if that trend continues.

"Although [the company's overall] third-quarter adjusted expense may appear elevated in comparison to our full-year target of $58 billion, it was substantially driven by higher market performance versus our earlier expectations," Marianne Lake, chief financial officer of the company, said during a conference call with analysts. "If the positive momentum continues in the fourth quarter it is likely that our total adjusted expense will be above $58 billion, but obviously on higher revenues."

Analysts seemed dubious – three separate analysts essentially asked if there was more to the updated guidance than just compensation. Lake assured them that in this case, the higher expenses were directly correlated to more revenue.

"We have always said that the adjusted-expense, absolute number in any period is obviously going to be calibrated to the performance of the market-related businesses," she said. "Clearly you would wave in good revenues every day at a 32% comp to revenue ratio."

The company's goal is to have a ratio of compensation to revenue of 30% to 35%.

Chairman and Chief Executive Jamie Dimon backed Lake up on the argument that the possibility of higher-than-expected expenses was connected to market volatility and anticipated trading volume.

"Remember, in the old days we used to break out [investment banking] comp in total for that reason," Dimon said.

Analysts are wary of the repeated costs stemming from legal problems, and that perhaps fueled the questions about the company's revised forecast, says Chris Mutascio, an analyst with Keefe, Bruyette & Woods.

"We're all tired of it," Mutascio said in an interview, referring to the frequent litigation-related set-asides. Still, he said that JPMorgan's expenses in the quarter were just a $100 million more than he expected when the litigation costs are excluded. Conversely, revenue was more than $500 million more than he expected.

"I thought it was interesting that the expenses were a lot of the focus in the Q&A," Mutascio said. "But paying $100 million to get $500 million in revenues? I'll take that all day long."

Still, Mutascio said it is tough to back out the legal fees. JPMorgan's expenses totaled $15.8 billion for the quarter, with $1 billion set aside for legal matters and a large portion of that is earmarked for potential foreign-exchange trading settlements.

Similarly Citigroup reported a $951 million legal-related expense, more than double what the bank outlined in the second quarter. Citigroup CFO John Gerspach flatly declined to elaborate on the nature of the possible charge.

Citigroup, in its drive to consolidate global operations and narrow its focus on large urban markets, took on another $382 million in restructuring costs, and it spent $60 million in the quarter to better prepare for its upcoming Comprehensive Capital Analysis and Review, which it failed in its last submission to the Federal Reserve. Gerspach said to expect lower restructuring costs in 2015. The bank otherwise reported flat operating expenses of $10.9 billion.

Both JPMorgan and Citi reported higher than expected revenue, but "Citi controlled the cost line a little bit better," said Ken Usdin, an analyst at Jefferies. Meanwhile, Usdin said that Wells Fargo's "revenues were OK, but expenses were higher than expected."

Wells Fargo's noninterest expense rose 1% to $12.2 billion from a year earlier, largely because the bank recorded $417 million in litigation accruals and because its risk management and compliance costs have increased by about $100 million per quarter as it upgrades those departments.

Even with the added costs, Wells Fargo expects that its efficiency ratio will be in a range of 55% to 59% in the fourth quarter.

"We're working constantly to try and be as efficient as we can in areas where it won't impact customers and where it doesn't hinder us in terms of our risk management activity," Chairman and CEO John Stumpf said during a conference call.

Yet Mike Mayo, an analyst with CLSA who pushed JPMorgan on the $58 billion cost projection, underscored the skepticism that the CEOs are facing. He reiterated the call from many quarters for clearer disclosures.

"After the financial crisis, analysts know now to not take what management says at face value. I'm not saying JPMorgan hasn't been better than others, but a healthy degree of skepticism is a good thing," Mayo said. "They can say [the potentially higher expense] is a good thing because they earned so much in trading, but it is nice to have more transparency."

Matt Scully and Andy Peters contributed to this article.