Beware of a New Banking Bubble

“As long as the music is playing, you’ve got to get up and dance.” With those immortal words, then-Citigroup (NYSE:C) Chief Executive Charles Prince explained in July 2007 what had motivated his managers to steer their bank into insolvency.

The multi-trillion dollar question that regulators and investors ought to be asking is whether bankers are again succumbing to the urge to shimmy while the shimmying is good.

There are a number of reasons to think they’re doing just that. Tops is the fact that with interest rates so low, there’s been a breakdown in the traditional “3-5-3” banking model—pay 3% on deposits, lend the money out at 5% and be on the golf course by 3 p.m.

Compressed net interest margins mean bankers face pressure to under-price risk to win loan business and to look to other questionable tactics to turn a buck.

Regulators’ ever-tightening grip on how bankers run their businesses is taking a bite out of fee revenue, too. Until recently, banks propagated the fiction that they offered “free” services like checking accounts, which in fact cost them around $350 a year to maintain. They recouped their costs and earned a profit by charging fees on the back-end. Some were of the “gotcha” variety, like those for over-drawing accounts, paying card balances late or for credit card payment protection plans of marginal value to buyers. The newly empowered Consumer Financial Protection Bureau has put a plug in many such revenue streams.

In addition to narrow lending margins and increased regulation, bankers are living in a world where animal spirits have returned to financial markets. Stocks and other “risk” assets are back in vogue. Greed is again trumping fear.

In what imprudent ways are bankers likely to respond to these various pressures? Take your pick.

Comptroller of the Currency Thomas Curry warned back in October that regulators were "ready to take action" against banks that boost earnings by releasing reserves with excessive haste. Comptrollers do not tend to talk in such hypotheticals unless there’s a genuine cause for concern behind them.

Federal Reserve Governor Sarah Bloom Raskin warned last month that “The pressure to generate enhanced profits through high fees is palpable, and banks may choose to move aggressively down these paths.”

One banking insider also pointed out to me this week that the owners of many small banks are looking to sell. With a high price tag as their beacon, the temptation to pretty the financials is strong. That may help explain the fevered competition to write commercial and industrial loans, he added.

“There are more people in the marketplace and they’re not acting entirely rational, so we all have to end up being more competitive and that means we have to sacrifice margin,” US Bank (USB) Chief Executive Richard Davis said earlier this week of the loan market.

Froth is bubbling up in bank M&A too. Three recent deals involved premiums of 32% to 83% above tangible book value, implying that buyers are willing to bet on the prospect that the targets will be worth more in the future than they are today. "We are seeing in-market [banks buying banks] deals with big expectations around cost savings,” Phil Weaver, a partner at PricewaterhouseCoopers told American Banker recently.

Cost-savings is another term for “synergy,” the buzz-word that over the years has impoverished shareholders and enriched investment bankers in roughly equal measure.

Think this time regulators will remove the punch bowl in time? Don’t fool yourself. Consider how blind they were to JPMorgan Chase’s (JPM) multi-billion dollar London Whale until they read about him in the press. Their early warning systems appear to be no better today than they were when Chuck Prince was leading the dance at Citi.

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