The narrative of the current market downturn, bear market, correction or whatever you prefer to call it had been about oil, China and the emerging markets. Now the banks have been put into play. Year to date their decline has outstripped that of last year’s whipping boys: energy, materials and industrials. Does it make sense that US banks, who were forced to raise equity via TARP, to hold more capital by Basel 3, to derisk by Dodd-Frank and the Volcker Rule, should follow European and EM banks into the vortex? I’m not sure.
S&P sector ETFs: YTD return to 2/16/16. Source: sectorspdr.com
No question that profitability will be permanently impaired by the need to hold more capital. That could lead to, and perhaps has already led to, a rerating of US bank stocks. However US banks should not be facing existential crises due to the above measures. I could see US banks becoming something like pro-cyclical utilities, given lower profitability and the decrease in riskiness afforded by higher capital and tighter regulations. What has occurred recently may have more to do with what is happening with banks in the rest of the world.
European banks still have issues. Many have been restoring capital by shrinking their balance sheets rather than by raising equity. There are genuine questions about their true capital positions, because they have extended loan maturities and ignored losses, realizing them as they accrue capital via earnings. It is a slow path towards balance sheet health. Inconsistencies surrounding the treatment of bondholders in the event of their resolution cannot have helped matters either. The recent swoon in their shares and bonds may be sudden, precipitous and, daresay it, overblown, but it is (somewhat) understandable.
Chinese banks may yet reap the whirlwind from their country’s astounding credit expansion . Pretty impressive 60+% increase in total credit to GDP between 2008 and 2014. It was probably higher still in 2015. Increases of that magnitude are generally good predictors of banking crises.
If that doesn’t convince you, Chinese bank loans outstanding surpassed the stock of US bank loans in 2010. And they have continued climbing at a vertiginous rate. Yes, US firms do finance via the bond market, so the US stock of loans should be lower relative to GDP than in a bank financed economy. But really, a bank loan stock that is 175% of the US loan stock for an economy 60% the size of the US economy? The Chinese government probably has the capacity to bail out its banks again. China will just grow slowly in the aftermath, unlike after the 2004 bailout.
US banks have had their crisis. They have been through the fire and are going to be less profitable than they once were, but they are much less likely to bring down the system or themselves. Increased capital requirements mean reduced leverage. Reduced leverage means lower returns to equity holders. Returns on equity (ROE) has dropped post crisis and should remain lower until the great recession passes from living memory.
Bank profitability has also been squeezed due to the decline in net interest margins (NIMs). NIMs have come down along with interest rates since about the mid-90s. This may have something to do with the excess of capital chasing returns, i.e., Ben Bernanke’s “savings glut” or with the disappearance of inflation. I don’t know, but bank lending spreads have compressed and profitability along with them. That is not likely to reverse anytime soon.
So in the end, I believe that bank equities should have lagged as they have done since the crisis. If banks are going to be low beta pro-cyclical utilities that seems right. The question is whether US banks should be exhibiting such stark differentials in performance versus the rest of the equity market at this time. That is not so clear to me.
Source: Financial Times