Investors will need to see they can endure a real downturn before giving them credit
Robert Armstrong
What did we learn from the avalanche of big US bank earnings this week? That the industry can take a hard punch — from interest rates falling to historic lows — and remain up on its feet.
Bankers and bank investors can breathe out, and start to think about whether there are more punches coming.
There was considerable anxiety coming into third-quarter results season. But the diversified giants, most notably JPMorgan Chase and Bank of America, showed real resilience. Most of the banks beat analysts’ earnings estimates, and a few of them by wide margins. Goldman Sachs, whose investment banking operation stumbled, was the notable exception.
Yes, revenue growth was lower because lending margins were tighter; lower interest rates and a flattening yield curve will have that effect. And the banks’ level of excitement about the state of the US economy has cooled somewhat. A year ago, for example, JPMorgan’s finance chief said: “We don’t see it slowing down.” This quarter, the economy was just “on a solid footing”. Such tonal downgrades were audible across the industry.
But even in the thinner air of late 2019, the banks’ business models are working. The big lenders are still collecting deposits, the lifeblood of the industry, at a healthy pace. Loan demand is holding up too. BofA’s loan book is growing at about 5 per cent, up by $43bn over the past year. Even Wells Fargo, its reputation under repair following the fake accounts scandal, is increasing its loans again.
As a result the margin compression, so far, has been moderate. Indeed, net interest income is still rising at the two biggest banks by market capitalisation, JPMorgan and BofA.
As a side note, it is interesting that the growth has different sources at the two banks. Both are harvesting prodigious flows of deposits — almost $140bn worth over the past year between them. But JPMorgan has said it thinks it wiser to invest that money into long-duration debt securities, which have modest yields but do not require much capital to be held against them. BofA, on the other hand, prefers higher-yielding, more capital-intensive loans. Only in the fullness of time, when the costs of impairments are counted, will we find out which strategy was smartest.
The banks can also depend on the US consumer. Credit-card businesses are humming across the industry with no spikes in defaults as of yet. Several of the banks were also in a position to take advantage of falling rates during the quarter, either by underwriting a bonanza in corporate debt refinancing (BofA was particularly active here) or trading volatile rates markets (JPMorgan and Morgan Stanley). Mortgage refinancing fees are rolling in, too.
Meanwhile, the banks are buying in boatloads of stock, keeping earnings per share on the rise. At Citigroup, for example, tightening lending margins kept pre-tax income flat, but repurchases helped push up EPS by 20 per cent.
“Three quarters in a row now, people have said, ‘rates are terrible, and the banks are going to get crushed’ — then the banks report and it’s ‘oh, there are other levers the banks can pull,’” said Brian Foran, a banks analyst at Autonomous Research.
Still, this durability earned the banks a pretty meagre reward from the stock market. The S&P Banks index climbed about 4 per cent over the week, while the broader S&P was up about 2 per cent.
Part of the reason for this is surely that, in the view of the futures market, the Fed is not finished cutting rates: the forward curve indicates one more cut this year. So lending margins are likely to compress in the fourth quarter, which will include the full impact of the cut in September, and another trim on top of that.
But lower base rates will not turn the US into sub-zero Europe or Japan, where the banks and big insurers are really groaning. The bigger question is how loans will hold up if the US economy truly slows.
Both non-performing loans and reserves for losses are low. This may be the result of 10 years of cautious, post-crisis underwriting; or so the banks insist (“responsible growth” has long been BofA’s mantra). It could also be that companies do not default when refinancing debt is as easy as it is now, and consumers do not go bust when unemployment is at an all-time low. Neither condition will persist forever.
In the previous recession, banks melted down in spectacular style.
They will need to prove they can punch their way through the next one and emerge with their balance sheets intact before they will get credit for the gym work they have done over the past decade.
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