WANT TO KNOW WHERE THE ECONOMY IS HEADED? LOOK AT THESE BANKS / THE WALL STREET JOURNAL

Want to Know Where the Economy Is Headed? Look at These Banks

Smaller lenders’ reports on business-lending growth may be a crucial signal for investors

By Telis Demos

Earnings season is kicking off this week for banks. Photo: John Taggart for WSJ

It’s been a tale of two markets in U.S. banking of late: Some of the best of times for megabanks, and not-so-great times for smaller lenders. 

In the second quarter, the KBW Nasdaq Bank Index, which tracks the country’s largest banks, was up 14%, beating the S&P 500 by about 3 percentage points. 

That was powered by some megabanks. 

Shares of Goldman Sachs, for example, were up almost 30%.

Meanwhile, the KBW Nasdaq Regional Banking Index, which tracks relatively smaller lenders, was up less than 3% in the second quarter.

This isn’t a huge surprise. 

Bigger banks have been a haven during many recent periods of volatility. 

Even so, such sharp outperformance is rare. 

Only in two quarters in the past decade has the bigger-bank index outperformed the smaller one by double digits, according to FactSet data.

Investors’ optimism for big banks might be proven out as earnings season kicks off. 

Citigroup , JPMorgan Chase and Wells Fargo are reporting on Tuesday, followed by Bank of America, Goldman Sachs and Morgan Stanley on Wednesday. 

Recent tailwinds for these “big six” banks include active trading desks and easing capital requirements. 

Merger and initial public-offering activity has also improved after April’s pause.

However, investors accustomed to thinking of banks as economic bellwethers might want to look past those results—and focus instead on regional banks, whose reports also start this week.

Perhaps more than ever, it is smaller banks whose fortunes more closely track activity in the real economy, especially for midsize, domestically focused businesses.

The tariff-induced volatility that can power trading desks in New York, London and Hong Kong is also what holds back business owners across the U.S. from making hiring or investment decisions. 

That dynamic can boost fees on Wall Street, but slow income growth at regional banks that make more of their money through traditional lending. 

You can see this most clearly in commercial-and-industrial loan activity, which has been anemic in recent years. 

There has been a pickup in such lending over the course of the second quarter. 

But only to about 3% year-over-year growth, according to weekly Federal Reserve data.

Many bankers have also attributed that uptick to the uncertainty brought about by tariffs: Companies drew down existing lines of credit. 

Often, this wasn’t to fund new capital expenditures, but to load up on inventory. 

In other words, companies were playing defense, not offense.

There is another headwind for lending. 

The kind of euphoria evident in the stock market is cropping up in credit markets, too. 

The premium investors demand to hold investment-grade corporate bonds over Treasurys is near its lowest levels since the 1990s, according to ICE BofA index data.

This suggests there isn’t much margin in lending to businesses. 

Some banks have noted that pricing in commercial-real estate lending, in particular, has been tight. 

Nonbank lenders flush with investors’ funds have been splashing cash around in these markets. 

Even if banks wanted to lend more, they risk doing so at prices that will haunt them in the future.

The biggest banks sidestep this pressure by lending to nonbank lenders. 

Smaller banks aren’t usually in that business.

When it comes to signals about the real economy, not financial markets, small banks will speak with the loudest voice.