- The US banking sector is adequately positioned to withstand the economic crisis brought on by the pandemic, even if low rates and the economic malaise persist for a long period.
- While the financial sector has not enjoyed as robust a recovery as the broader market this year, a closer look at the industry scorecard should offer more comfort for investors.
- Since the last crisis, the Global Systemically Important Banks (G-SIBs) have improved their capital ratios with resilient buffers to withstand near-term shocks. Strong balance sheet liquidity is a bright spot for banks as well.
This month’s main article examines how the US banking sector is adequately positioned to withstand the current economic downturn.
Banking: It's different this time
Fiona Nguyen, Senior Credit Risk and Research Officer
After an impressive summer rally, major stock indices have crossed their pre-pandemic thresholds, and several are inching toward all-time highs. That’s an incredible turnaround since the dark days in March and April. For the month of August, the S&P 500 was on pace to reach a new record, powered by the technology sector led by giants such as Apple and Amazon. Yet the rally seems to have left behind an important segment of the economy: the financial sector. This sector was still down roughly 30 percent year-to-date amidst worries that low interest rates and pandemic-driven credit losses would cripple bank earnings for many quarters to come. Those are valid reasons to be concerned, as investors, equity and fixed income alike often pay attention to the same financial metrics and outlook signals. And up until the second quarter of 2020, the outlook offered by the banks spurred little optimism for a quick turnaround. Nonetheless, rather than focusing on earnings prospects, a closer look at the industry scorecard should offer more comfort for investors in the financial sector, as there are defensive factors that position the industry positively as compared to the last financial crisis.
As a reminder, banking sector performance historically has been cyclical, as it tends to rise and fall in sync with the broader economy. Facing pandemic headwinds, the eight US global systemically important banks1 (G-SIBs) in aggregate posted relatively weak second-quarter 2020 earnings compared to the previous year. This was mainly driven by elevated loan loss provisions and thinner net interest margins (NIMs), despite strong revenue growth from other sources, such as capital markets and mortgage banking. The primary reason that banks put aside such outsized provisions is the untimely compounded effect of the new accounting standard — Current Expected Credit Losses (CECL).
Under the new methodology, banks must estimate lifetime losses across their loan portfolios using economic forecasts that can vary from moderate to severe assumptions. With asset quality still at a good level outside of pockets of loans to energy companies, large reserves mean banks have erred on the side of caution. Moreover, the accommodative monetary policies and government fiscal measures have lessened the immediate concerns for credit erosion. In response to impending asset quality deterioration, the industry has been tightening lending standards. According to July 2020 Federal Reserve data, banks tightened their lending standards across all loan categories for the second quarter of 2020, particularly within commercial and industrial loan books. While delinquencies and net charge-offs are expected to accelerate in the second half of the year, the large reserve built in the first half should allow banks to absorb losses and still remain profitable.
Staying profitable is not only important from a market confidence perspective, it is also essential in maintaining capital adequacy, since profits speak to the banks’ internal capital generation capabilities. Since the last crisis, G-SIBs have gradually built up their capital ratios with buffers wide enough to withstand near-term shocks, primarily through profit growth. At the start of the pandemic and under the Fed’s guidance, the industry unanimously curtailed share repurchases to preserve capital ratios. During the second quarter, the decrease in loan growth and associated risk-weighted assets, along with regulatory easing for CECL, also helped the ratios rebound and remain well above regulatory minimums. Lest we forget, this past summer the Fed’s stress test concluded that large banks have sufficient capital to weather a traditional severely adverse scenario. In a separate test that incorporated scenarios reflecting COVID-19 stress, some banks approached but still did not breach minimum required capital levels. It is not a coincidence that many banks that performed well on the stress test are also highly rated, including several G-SIBs and regional banks.
There were other encouraging clues that suggest this time will be different for the banking sector. Looking at the aggregate balance sheet, for example, liquidity stands out as another bright spot. According to August 2020 data published by the Federal Deposit Insurance Corporation (FDIC), the banking sector’s deposit balances increased by $1.2 trillion, or 7.5 percent, from the previous quarter. G-SIBs, in particular, have been the primary beneficiaries of the large inflow of deposits and cash balances driven by institutional clients parking their excess liquidity at the banks. Robust liquidity is also bolstered by the Fed’s accommodative monetary policy and, partly, by management teams’ conservative risk postures in response to liquidity risk management. In fact, abundant liquidity is in stark contrast, compared to funding strains in the previous crisis.
Looking past the dreadful economic statistics from the first half of 2020, there are constructive signs that suggest the economy has started to revive, albeit slowly. Banking outlook points to more moderate credit provisions in the third quarter, although the shape and pace of recovery will determine if reserves are sufficient. There remains the risk that economic downturn will persist longer or that there will be a rebound that is bumpier or “U” shaped. Yet we believe the banks have positioned themselves adequately by diversifying revenue sources and taking conservative stances in risk management, while continuing to buttress their capital bases in case of harsher economic stress. To quote FDIC Chairman Jelena McWilliams, “…the industry has remained a source of strength for the economy.” Perhaps this time we should give the banking sector more credit.
1Bank of America Corp., Bank of New York Mellon Corp., Citigroup Inc., Goldman Sachs Group Inc., JPMorgan Chase & Co., Morgan Stanley, State Street Corp., and Wells Fargo & Co.
Paula Solanes, Senior Portfolio Manager
The latest economic data shows the US economy has rebounded from the lows back in March and April. Although that is very good news, it’s important to acknowledge that the recovery is ongoing and there is still work to be done.
Despite the rebound, the labor market has a long road ahead to return to the near-full employment of pre-pandemic times. In March and April, the US economy shed more than 22 million jobs, but in the last four months, the economy has regained almost 10.7 million of those. As job growth recovers, the unemployment rate has improved from a peak of 14.7 percent to 8.4 percent in August. Average hourly earnings — which spiked in April to 7.9 percent, as so many lower-paying jobs were eliminated by shelter-in-place mandates — have more recently decreased to 4.7 percent. This is an indication that a variety of job functions have resumed, and many low-wage workers are employed again. Finally, the labor participation rate has also recovered to 61.7 percent from a low of 60.2 percent. All that suggests the labor markets are trending in the right direction.
In terms of inflation, which is the Fed’s second key mandate after employment, there appears to be recovery after dropping precipitously in the first half of the year. The core consumer price index (CPI), which excludes volatile items, such as food and energy, jumped 1.6 percent in July, driven by increases in the costs of vehicles and apparel. However, the Fed’s preferred measure of inflation, core personal consumption expenditures (PCE), remains subdued at 1.25 percent and well below the Fed’s target of 2.0 percent. This suggests that deflation is in the back of the Fed’s mind and why it maintains its current accommodative monetary policy.
Retail sales have also been trending higher over the summer. A sharp 8.4 percent rebound in June was followed by a 1.2 percent increase in July. While the value of total retail sales was restored back to pre-pandemic levels, a deeper look reveals that spending has shifted dramatically. We have seen increases in online sales and at grocery stores, offsetting declines in retail stores, restaurants and bars. Given the challenges posed by the pandemic, it will be some time before these sectors rebound. Looking at the 13 major categories of retail sales, nine posted increases with the biggest gains coming in electronics and appliances.
Meanwhile, the housing sector is acting markedly different during this downturn, as compared to the global financial crisis in 2009. New home sales were up 13.9 percent in July, the highest level since 2006, buoyed by low mortgage rates and limited inventory of existing home sales. The median sales price for new homes was up 7.2 percent. Existing home sales also registered a 14-year high, as median prices were up 8.5 percent. With the shift to working from home and a greater emphasis on staying local, homebuyers are looking at places that provide more space, offices and outdoor amenities, and the record-low interest rates are helping by making borrowing costs very attractive.
Overall, the economy appears to be trending in the right direction. But it’s important to keep perspective of just how much it contracted earlier this year. The first estimate of second-quarter GDP revealed the worst quarterly plunge on record since World War II, a decline of 32.9 percent. The revised second estimate deviated only mildly and confirmed an annualized quarterly decline of 31.7 percent.
In August at the annual economic symposium, the Federal Open Market Committee (FOMC) unveiled plans to officially adopt an average inflation target (AIT) whereby the FOMC would allow for inflation to overshoot the two-percent target following times of low inflation to achieve an average of two percent over a period of time. On the employment side of the mandate, the Fed also left room to be more accommodative, even if employment achieved its maximum level. Overall, this is a dovish tone from the Fed and a shift from its previous approach toward its two mandates.
As we enter the last month of the third quarter, we continue to watch data closely to better understand the trajectory of the economy. In the meantime, we expect the Fed to continue to remain accommodative for an extended period to help support the economy as the quest for a vaccine continues.
Tim Lee, CFA, Senior Credit Risk & Research Officer
Canada’s economy contracted by 38.7 percent in the second quarter, as the pandemic stifled the economy and led to an unemployment rate of 13.7 percent in May, the highest since at least 1976. Just a year prior, unemployment was at 5.4 percent, a more than four-decade low. Amid one of the deepest recessions in Canadian history, some investors might be worried about the health of the banking sector. Yet Canada’s six largest financial institutions continued to generate profits and maintained steady capital levels throughout this storm, thanks, in part, to the oligopoly they enjoy.
The “Big Six” domestic systemically important banks that make up the oligopoly — Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce and National Bank of Canada —account for approximately 90 percent of total assets among the country’s deposit-taking institutions, according to Canada’s Office of the Superintendent of Financial Institutions (OSFI). For comparison, the six largest US banks accounted for 49 percent of total consolidated assets, according to the Fed as of June 2020. While the Big Six still compete among themselves and with credit unions and other niche financial services companies, they are the only domestically domiciled banks with a nationwide presence and international reach.
The dominance of the Big Six is reflected in the underlying earnings power these banks maintain. Despite the COVID-19 lockdown, aggregate pre-tax, pre-provision profits for the Big Six was C$18.5 billion in the quarter ending July 2020, which was 10 percent higher than the prior year’s quarter.
Strong underlying profitability, anchored by their domestic franchises, provided room for the banks to take provisions against future fallout from COVID-19. While provisions were chiefly responsible for the fall in net income, each of the six banks has remained profitable this year.
Positive net income has meant each bank continues to internally generate capital on a quarterly basis, which has helped to keep CET1 percent steady through the pandemic thus far.
Despite a 125-basis point decrease in the Domestic Stability Buffer by OSFI in response to COVID-19, capital levels for the Big Six did not drop and continued to maintain a prudent buffer to minimum requirements.
Looking ahead, we expect provision charges will continue to be elevated and write-downs to move higher. However, the Big Six have built a mighty war chest against losses with the provisions they have taken thus far in 2020. As of the most recent quarter ending in July, the average loan loss reserve ratio has exceeded the peak level reached in the January 2010 quarter during the aftermath of the last recession.
With loan loss reserves at substantial levels, the Big Six banks are well positioned to handle any potential surge in write-downs, particularly as we expect the banks’ underlying earnings power will provide ample resources for future provisioning. Internal capital generation should remain good, particularly over the near term as their mortgage holdings, which on average account for around 42 percent of total loans and acceptances, are performing very well with very limited net losses. Sheltered by an oligopoly, we believe these six banks will maintain a steady credit profile.
Hiroshi Ikemoto, Fixed Income Trader
With the unprecedented stimulus provided by the government and the Fed’s mandate to keep funding rates near zero, this summer has been like no other in recent memory. Historically, the summer months are the slowest times in the bond market. But nothing is normal this year. It could be traders are not taking vacations per usual. Or maybe the Fed is keeping everyone on their toes.
Despite the fact that the world is still handcuffed by COVID-19 and the subsequent global economic downturn it has caused, the bid in the bond market has remained robust. Yields remain low, as investors scramble to capture income in a new world where credit risk is being protected by the government. The lack of clarity from Congress with respect to an additional stimulus package has also hindered Treasury bill supply. While benchmark Treasury and London Inter-bank Offered Rates (Libor) have remained at all-time lows, spreads on corporate debt continue to tighten on strong demand, as investors seek any possible yield advantage.
Another indication of the strength in this market has been the record-setting issuance of investment grade bonds in August and for the entire yield. Corporations have been opportunistically extending their debt to shore up balance sheets amid the economic uncertainty, while also looking to reduce exposure to short-term financing, like commercial paper, which can sometimes be volatile. With more than $136 billion bonds issued in August, high-quality issuers have had little trouble taking advantage of the current low interest rate environment. The lack of vacations taken by investors and underwriters during the pandemic has also helped spur transactions of new bond issuance to an all-time high for a single year after only eight months.
Even with the unprecedented safeguards the Fed has established for the bond market, not to mention the considerable fiscal stimulus provided to corporations by the government to date, we continue to independently analyze the credit quality of the issuers and are sticking with our philosophy and disciplined investment strategies. Thus, we remain committed to sector and duration diversification, while providing ample liquidity in these uncertain times.
|Treasury Rates:||Total Returns:|
|3-Month||0.09%||ML 3-Month Treasury||0.01%|
|6-Month||0.11%||ML 6-Month Treasury||0.01%|
|1-Year||0.11%||ML 12-Month Treasury||-0.03%|
Source: Bloomberg, Silicon Valley Bank as of 8/31/20