Is the Five-Year Assault on Bank Earnings Power Finally “Tapering”?
Christopher Mashia, CFA, U.S. Financials Sector Head
August 27, 2014
On August 21, 2014, the Department of Justice and one of the largest banks in the U.S. announced agreement on a record mortgage settlement for nearly $17 billion. This clearly is not the end of the financial services industry’s legal woes, which still include large-scale cases on LIBOR rate setting, foreign exchange manipulation and foreign hiring violations, among others. However, we do believe the agreement represents an inflection in the magnitude of litigation costs incurred by an industry that has faced financial pressures on several fronts since the beginning of the Great Recession and through the recovery.
More specifically, five key pressure points have degraded the earnings power of large cap banks since the financial crisis unfolded:
Record low interest rates squeezing net interest margins (NIMs)
Limitations in capital return to shareholders
Legal and regulatory expenses
Weak growth, due to deleveraging in the U.S. economy and regulatory pressures on fee income
Some of these pressure points, such as credit-related losses, have reversed sharply to enhance bank earnings power but most have remained stubbornly elevated. However, we believe that most—if not all—of these headwinds will likely be alleviated materially over the next few years.
Rising Interest Rates Should Benefit Banks
It has been more than five years since the Federal Reserve lowered its target interest rate range to 0-25 basis points. While banks were initially able to absorb the impact of falling rates by lowering the cost of deposits and refinancing into lower-cost borrowings, the low rate environment eventually began to materially degrade margins. Despite reasonable levels of asset growth in recent years, net interest income remained stagnant and, in some cases, growth was negative. Considering the steady improvement in U.S. employment, the normalization of inflation levels, and indications from Chair Yellen and other Fed officials regarding completion of the tapering program and tightening prospects, we believe it is increasingly likely that rates will move higher in 2015.
In our view, large cap banks should all benefit to varying degrees from rising rates (Figure 1), especially from a rise in short-term rates driven in large measure by re-pricing in:
Commercial prime-based lending
Deposit re-pricing that lags a higher fed funds rate (some from non-interest bearing deposits and some from other transactional and core deposits that tend not to be very rate sensitive)
Even for those who believe rates are unlikely to rise to levels seen in the past (e.g., Bill Gross’ “new normal”), a 100 to 200 basis point increase in short-term rates should be viewed a considerable boon for large cap bank NIMs and earnings-per-share (EPS).
Figure 1: Historically, a Steepening Curve Has Benefited Bank Stocks
Past performance is no guarantee of future results. Source: Bank of America Merrill Lynch, Erika Najarian and Ebrahim H. Poonawala, August 2014, using data from Bloomberg, BAML Global Research Estimates.
Capital Improvements: Far-Reaching but Overlooked
Since the financial crisis, the banking industry has achieved significant capital improvements. Even so, the market remains more focused on the negatives of today’s tough regulatory environment. Overall, bank capital levels have reached levels not seen since the post-Great Depression era, but this appears to be overshadowed by the opacity in which capital return is approved (or not) by the Fed through its annual “stress test,” the Comprehensive Capital Analysis and Review (CCAR). For example, investors were reminded of the CCAR’s unclear criteria when a large bank failed its stress test in 2014 for qualitative reasons, despite soundly passing on quantitative measures.
Nevertheless, we see many reasons for optimism going forward, including the success of several bank holding companies (BHCs) in navigating the CCAR process, capital levels that continue to build well above more stringent Basel 3 requirements, as well as the completion of many high-profile legal settlements. In several instances, the Fed has eventually been willing to unleash capital returns (e.g, share repurchases and dividend increases) for BHCs, having been satisfied by the overall level of capital (quantitative) and strong controls and stress-testing capabilities (qualitative).
Figure 2: Bank Capital Levels Have Reached Multi-Decade Highs
Source: KBW Capital Research, FDIC
Litigation and Settlement Costs Are Likely Abating
Over recent years, the banks have been highly disciplined and quite successful in lowering operating expenses. This success is attributable to several factors, such as a generally low wage inflation environment, as well as management teams’ willingness to restructure, including selling off underperforming units, reducing staffing where possible to protect return on equity, and embracing the secular trend of consumer adoption of technology (mobile/online banking, smart ATMs). Over time, these efforts should continue to reduce the need for some bank branches, while also lowering staffing levels within branches and allowing for smaller (and cheaper) technology-focused branch layouts.
However, litigation and settlement costs have been considerable expense headwinds that have substantially depressed margins and overshadowed operating expense reductions. Additions to litigation reserves have occurred for so many years that they now obscure the true earnings power and operating margins of the business.
As I mentioned earlier, the banking industry will continue to face a steady stream of lawsuits. However, we believe the magnitude of the settlements should be materially reduced going forward as the completion of the largest mortgage settlements mark a meaningful inflection in litigation reserve build.
Banks Benefit from Marked Credit Improvement
Credit quality has massively improved for the industry since the depths of the financial crisis. Commercial losses are near zero and consumer losses are at record lows, with the exception of mortgages. On the whole, losses remain below normalized levels and provisions for loan losses are even lower as reserve releases continue for most banks, albeit at reduced levels.
Mortgage loan loss levels are still pressured by pre-crisis loans with poor underwriting standards and high loan to value levels, but stressed legacy loans are quickly being replaced by portfolios of post-crisis mortgages originated with exceptionally stringent underwriting standards, which we believe should produce losses that are among the lowest we will see over the decades to come.
While we do not foresee credit improvement as an earnings driver, we do anticipate a broadening of strong credit as lifting a major perception issue with some investors who have been hesitant to trust the quality of bank balance sheets. An increasingly pristine credit environment and high bank credit standards should also encourage regulators to lighten their grip on large banks’ share repurchase and dividend decisions.
Figure 3. Mortgage Losses Have Nearly Recovered to Normal Levels
NCO stands for net charge-off, or losses net of recoveries. Shaded areas indicate recessions. Source: Morgan Stanley Research North America, “Large Cap Banks,” August 5, 2014, Betsy L. Graseck, CFA and Manan Gosalia, using data from the Federal Reserve, FDIC and Morgan Stanley Research. FDIC data for 2Q14 not yet available. *Federal Senior Loan Officer Survy on lending standards
Growth Prospects Should Improve
Weak top-line growth has been a key headwind for large cap banks. Investors often cite a hesitancy to pay for EPS improvement driven by expense cuts and share buybacks versus core growth. A variety of factors have had a negative impact on revenue growth at large cap banks since the financial crisis began. Most notably, banks have absorbed substantial deleveraging within consumer lending, while a low rate environment has pressured NIMs, and a number of fee-income streams have been hindered by new regulatory requirements emanating from the Dodd-Frank Act, including the Durbin Amendment, the Volker Rule, and the formation of the Consumer Financial Protection Bureau (CFPB). However, our view is that today’s growth is stronger than a simplistic focus on recent revenue growth trends would imply. Consider the following:
The impact of poorly underwritten legacy loans (pick-a-pay mortgages, for example) is a waning headwind as all of the large banks have been heavily running off pre-crisis loans with poor underwriting.
NIM pressure has offset otherwise fairly strong growth in deposits and earning assets more recently. Banks have been dealing with a low interest rate environment and at the same time have been building liquidity to prepare for a rising rate environment. This headwind will become a meaningful tailwind as soon as short-term rates rise.
Loan growth, M&A, capital market activity, and trading should all benefit from an improving economic environment.
As a result, we expect that the headwind of weak top-line growth should continue to fade over the next few years as the economy continues to recover, non-core loan run-off recedes and NIM pressure abates and ultimately reverses with a rise in short-term rates.
An unprecedented level of new regulation and litigation, as well as a particularly difficult interest rate environment has hampered the recovery in large cap bank earnings following the Great Recession. It is our view that many of the key pressure points plaguing the industry should recede over the next few years, paving the way for improved earnings power and investor sentiment. We believe the extensive due diligence of our sector teams will serve us well as we identify companies that are most likely to benefit from improving trends—before such positive inflections are recognized by the broader market.