Banks’ latest earnings results contain words like “record,” “outstanding” and “double.” So far, 2023 has been a superb yr for the industry, at the least from an earnings perspective.
But bank share prices haven’t yet surpassed their previous highs. The KBW NASDAQ Global Bank Index, which tracks global banks, has seen little growth because the current rate hike cycle began in early 2022 and has generally not exceeded its pre-COVID-19 highs. Other bank indices haven’t outperformed either. The S&P regional bank index is trading at 2016 levels.
Banking is a posh sector with many influences. To understand the medium to long-term outlook, we want to know the three key drivers at work within the industry today.
1. The transition to a better rate environment
The Federal Reserve’s rate of interest hike cycle has been the fastest in many years, and the banking sector has benefited. When rates of interest rise, a bank’s assets are inclined to change faster than its liabilities, and thus a bank’s net interest income, which accounts for the vast majority of its earnings, increases. This is precisely what has happened in the present rate of interest cycle, which has provided a tailwind for financial stocks within the industry.
But higher rates of interest are a double-edged sword. Many banks built large portfolios of long-dated securities within the easy-money era, and their prices collapsed as rates of interest rose. Hold-to-maturity accounting has protected banks’ funds from the results. However, should these portfolios be liquidated, the losses will occur and the bank’s capital can be affected. This is an industry-wide problem, as W. Blake Marsh and Brendan Laliberte indicate in “The impact of unrealized losses on banks.”
In fact, the transition from a low or negative rate of interest environment to at least one with a positive but inverted yield curve occurred quite quickly. Could this spell trouble for banks? According to financial theory, banks perform maturity transformation—borrowing short-term to lend long-term—so the reply to the query could, in theory, be yes. In practice, nevertheless, banks borrow and lend at different points within the curve, and the typical maturity of loans and securities tends to be lower than five years. Additionally, assets and liabilities are well aligned, so banks can still generate profits with an inverted yield curve. Actually in “How have banks responded to changes in the yield curve?“Thomas King and Jonathan Yu find evidence that banks actually increase their net interest margin when the curve is flat.”
2. Reduced competition from neobanks
Neobanks and fintechs are the results of low rates of interest and technological disruption. Low rates of interest forced banks to search for alternative sources of revenue given the historically low spreads on their bread-and-butter products, which meant charging higher fees on bank cards, money transfers, etc. to generate interest-free income. In combination with old technology stacks and start-ups financed with low-cost money, tough competition emerged for traditional banks. Until the fintech winter arrived.
As easy funding rounds change into a thing of the past, most neobanks will struggle to survive. The overwhelming majority haven’t yet reached profitability and can now not have low-cost financing options to bridge the gap. Furthermore, pressure to extend service fees will ease as banks revive their reliance on traditional sources of revenue – interest income. With all of the hype around customer experience and digital disruption, neobanks could have a tough time retaining customers if their fees are kind of the identical as traditional banks. Some banks may even be tempted to go on the offensive and cut their commissions, as their interest income provides a financial cushion.
3. Market multiples
How are the market variables developing for banks? Not superb. The sector remains to be undervalued in comparison with other industries. The price-to-book ratio is the universal banking multiple, and lots of banks are still below the magic value of 1. There are several reasons for this. Even if yields are improving, there are clouds on the horizon. Unilateral government measures through direct taxes like in Italy, increased regulation and extra capital requirements are all possibilities. Bank compliance departments have gotten ever larger and are placing an ever greater burden on profitability.
Another headwind is unrealized losses on securities portfolios. How tall are you? Big enough to trigger a liquidity event? We do not know, and that poses additional risk to the industry.
Another challenge is recent production – slower credit growth on account of tighter conditions and a deteriorating economy. Germany and Holland are already in a technical recession, and whether the United States can avoid one in a better rate of interest environment is unclear. Recent GDP readings have been robust and the labor market is resilient, explaining why US banks are trading at higher price-to-book ratios than their more subdued European peers. But even within the United States, delinquency rates on bank cards and auto loans are starting to rise, and the prospects for the housing market appear bleaker the longer rates of interest remain elevated.
I’m looking forward to
The banking sector is in higher shape today than it has been within the last decade of low or negative rates of interest. The fintech winter will reduce competitive pressure and provides some banks the chance to amass neobanks and acquire their technology stack. However, latent losses in banks’ securities portfolios, the political temptation to over-steer and over-regulate the sector, and the damage that higher rates of interest could cause to the economy could cloud an otherwise optimistic outlook.
The next few quarters are prone to present each significant challenges and opportunities.
If you enjoyed this post, do not forget to subscribe.
Photo credit: ©Getty Images / sakchai vongsasiripat
