In recent news, RBC Capital Markets makes some interesting points on Bank of America and Citigroup given the low returns on invested capital. Here’s what they mentioned in a report released today:We recognize that our analysis has many assumptions, the largest of which is normalized interest rates. Should interest rates stay at these levels for an indefinite period of time, reaching our targeted ROACEs will be difficult for all of the banks. In a prolonged lower interest rate environment, BAC and C would find it very difficult to have their ROACEs exceed their cost of capital. As a result, investors may demand that these banks choose a radical plan to lower their GSIB equity buffers by breaking into smaller entities. We believe a sum-of-the parts analysis suggests that breaking up these companies could unlock shareholder value, but the difficulty in this approach is that the cost of doing so may be prohibitive. ROACEs refers to return on average capital employed, which implies that if Bank of America and Citigroup continue operating in this environment, their cost of deposits may exceed the expected return from deploying capital. I.E. these banks may remain less profitable for quite a while longer, and to avoid the heightened capital ratios for bigger banks, the two firms may need to segregate its business operations to maintain profitability. However, from what I’ve seen and understand maintaining scale/size reduces risks from each different business unit. While, the two banks are less profitable when based on historical measures with net income/average asset ratios below the 12-year average, I find it somewhat improbable that the banks will look to generate shareholder value via a series of spin-offs. However, I do think the logic via RBC’s report makes a lot of sense. Source: RBC Capital Markets JPMorgan Chase and Wells Fargo are able to sustain higher pro forma leverage factors (based on RBC’s report), which is total risk weighted assets divided by tier 1 common equity. Currently, the pro forma leverage factors for the big banks are: 11.1x, 10x, 9.5x, and 11.1x for JPMorgan Chase, Bank of America, Citigroup and Wells Fargo respectively. As you can tell, both JPM and WFC sustain the highest leverage ratios, because their assets are concentrated in less risky buckets. Because RWAs are calculated by risk profile, banks that are more concentrated in less risky assets are able to generate higher returns for shareholders. This is because lower risk assets reduce the amount of tier 1 equity required to back those assets. Therefore, RBC’s projection on ROACE (return on average capital employed) is much higher in the case of JPMorgan and Wells Fargo. However, Wells Fargo has struggled with growing its deposit base as of late, which implies that as a group you’d have to be really selective here. I’m a much bigger fan of JPMorgan as opposed to Wells Fargo. Yes, I know Buffett regularly endorses Wells Fargo, but the company’s ability to further improve expense leverage is somewhat questionable, which may limit EPS growth. The firm’s efficiency metrics are fairly strong, and further efforts to improve on cost may have limited impact going forward.