The banks have been reporting first-quarter earnings over the past week, and the results have been lackluster. But I’ll start with the good news. Credit is trending in a very positive direction, for now. Most of the banks have come to the conclusion that loan losses will not come close to their previous dire projections. There are several reasons for that. The first and most obvious reason is that the labor market is improving fairly dramatically, with the unemployment rate having dropped to 6.0% from a high of 14.8% and 14 million people added to payrolls since May. In addition, most individuals and families have just received another round of economic assistance checks. Many are using those checks to make payments on their debt, regardless of whether or not they are employed. And finally, the mortgage foreclosure moratorium was extended until June 30, and many banks are extending forbearance for additional categories of consumer debt. These actions are helping to keep loss rates on consumer loans very low.
On the business side, loss rates are expected to remain broadly in check as well. Many borrowers operating in heavily impacted industries, such as hospitality, commercial real estate, retail, restaurants, and travel & leisure, have received government PPP loans or terms modifications from their lenders. This support has helped many businesses to build a bridge to mass vaccination. At the same time, an insatiable investor demand for investment yields has allowed larger corporations to tap the public debt markets at very low interest rates. Some corporations have used the proceeds from bond sales to pay down bank debt. And so to date, at least, the various responses to this unprecedented crisis have minimized bank credit losses. If all continues to go well with the inoculations, banks should be able to drop more reserves to their bottom lines in the quarters to come.
The second positive is that capital markets revenue, to include trading, investment banking, and asset management, have been very strong for the past few quarters. Obviously not all banks engage in these activities. Smaller regional banks tend to have less exposure to capital markets activities, while money center banks (like Bank of America, Citigroup, Wells Fargo and JP Morgan) and capital markets firms (Goldman Sachs and Morgan Stanley) have benefited the most. The surge in capital markets activity reflects positive investor sentiment and the widespread desire to benefit from the economic resurgence associated with mass inoculation. A flood of central bank liquidity and government fiscal stimulus has contributed to the massive surge in stock prices and desperate demand for yield.
That’s the good news. The bad news is that bank investors tend to ascribe less value to earnings that come from non-recurring sources. For example, there will come a point at which banks can no longer drop loan-loss reserves to the bottom line. The credit environment can only get so good, and at some point there will be a turn in the cycle. The same is true for trading and investment banking revenues, which are seen as cyclical or episodic at best. Some bank analysts fear that capital markets firms are simply “pulling forward” investment banking and trading revenue while the conditions are ripe. The inevitable result, they believe, will be that activity will take a sharp turn for the worse. And finally, banks earn higher management and incentive fees as asset prices are rising. This won’t always be the case. The inherent volatility to all these businesses causes their performance to carry far less weight as compared to the banks’ more stable source of income.
The most stable, predictable, and therefore highly valued source of bank earnings is their bread-and-butter business: taking deposits and using those deposits to make loans that earn higher yields. Unfortunately, lending activities appear to be stuck in the doldrums. Loan growth has been negative in recent quarters, and net interest margins (the spread between what banks earn on their assets and what they pay for their liabilities) are still falling for many banks. There are many reasons why spread lending has become more difficult for banks:
- Loan demand surged at the onset of COVID as businesses drew off their credit lines to ensure they had emergency cash to operate. Those borrowings are now being paid down.
- Loan demand is also weak because consumers are using economic assistance checks to pay down their credit cards and other debt.
- Despite the vastly improved outlook with respect to the pandemic, businesses remain reluctant to make investments in inventories and expansion projects. One reason for the investment deferrals is that bank management teams remain cautious about the durability of the economic recovery due to lingering COVID concerns, trade tensions, expected tax increases and additional regulatory oversight. Another reason is that capacity utilization remains very low, meaning many businesses have idle capacity they can use before adding more. And finally, supply chain disruptions have inhibited the normal process of inventory building for some companies.
- There is a shortage of residential housing, and the shortage is limiting home sales activity and purchase mortgage originations (as opposed to mortgage refinancings).
- Banks have been carrying excess liquidity and capital to ensure compliance with more onerous regulations resulting from the crisis.
- The Fed cut short-term interest rates back to zero following the arrival of COVID, reducing the rates banks are able to charge on certain types of loans.
- A surge in deposits has made it difficult to reinvest these funds at attractive yields.
A case study for the lending-related weakness that banks have been experiencing is PNC. The first chart below shows that PNC had grown its average loans, aided by a few minor acquisitions, in steady fashion until it experienced a surge in the second quarter of 2020. As mentioned above, that surge was related to borrowers drawing on their credit lines for use as emergency funding during COVID. Since that surge, however, PNC has experienced three sequential quarterly declines in average loans, with a cumulative decline of 11%. Average loans in the first quarter of 2021 were back at a level last seen in the third quarter of 2019. Coincident with the drop in loans over the past four quarters, PNC has experienced a sizeable drop in its Net Interest Margin (NIM) to 2.27% from 2.84% in the first quarter of 2020. This decrease was due to the drop in loan balances as well as lower interest rates, including the Fed’s move to lower short-term rates back to zero after COVID hit. The combination of the drop in average loans and the NIM compression led to 7% drop in net interest income from the first quarter of 2020 to the first quarter of 2021.
Though short-term rates remain close to zero, longer-term rates have been rising since the middle of 2020. Under normal circumstances, we might expect higher long-term interest rates and a steeper yield curve to positively impact bank NIMs. Is there some other factor inhibiting PNC’s NIM? Well, one of the factors is the massive amount of money PNC has on deposit at the Fed. The bank said it had a huge $85.8 billion (equal to 36% of its total loan portfolio) parked with the Fed at the end of its first quarter. One year ago, PNC had only about $20 billion in deposits with the Fed. These deposits earn just 0.10% annually, dramatically affecting the bank’s blended asset yield and its NIM. Meanwhile, the average yield on PNC’s loan book was 3.38% in the first quarter of 2021, and the average yield on its bond portfolio was 1.97%. By my calculations, if PNC were to reinvest the $85.8 billion in deposits held at the Fed into loans and securities at a 50/50 mix, the bank would earn an additional $2.2 billion in net interest income annually. This would increase the bank’s net interest income by 23% and its total revenue by 14% (compared to 2020 levels). Herein lies the opportunity not only with PNC, but the bank industry at large.
As a result of all the positive developments relative to the doomsday projections of one year ago, we believe the banks are in great shape. That said, bank valuations are factoring in a lot of that improvement with the KBW Bank Index up 72% in the past year. In my view, further gains for this sector will require not only a continuation of the positive credit trends, but also a reversal in the trends of shrinking loan portfolios and NIMs. Based on some management commentary, the wait may be longer than we previously thought. Even so, there are opportunities in bank stocks for those willing to take a longer-term view. We favor banks that will be consolidators and therefore will benefit from the expense and revenue synergies associated with the integration of large-scale acquisitions. We also favor banks that have already made the investments in technology necessary to remain competitive to other banks and FinTech startups. And finally, we are attracted to strong balance sheets, including excess capital and liquidity that will provide flexibility to be opportunistic going forward.