What started out as a promising 2020 for U.S. bank stocks was upended by the coronavirus outbreak. Through much of late February and into early April, uncertainty over the duration of the public health crisis and its human and economic toll became so pervasive that any short-term investment outlook became highly speculative.
Markets welcomed the U.S. Federal Reserve’s aggressive and rapid response, but one aspect of its initiatives—a series of interest-rate cuts—darkened the outlook for banks. The combination of ultralow rates and elevated risks from loan losses weighed heavily on the industry, and bank stock valuations fell to extreme levels.
However, fundamentals came into clearer focus in mid-April as banks began to report first-quarter results as earnings season opened. While U.S. bank stocks had plenty of ground to make up from their recent underperformance relative to the broader equity market, the initial batch of earnings bolstered our belief that banks remain a source of untapped potential. We believe that attractive valuations and the industry’s record of compounding book value provide a favorable entry point for long-term investors. While short-term hurdles remain, initial earnings reports suggest that banks remain financially well positioned to weather the current economic storm. Looking out further, we believe that many of these banks are likely to return to pre-COVID-19 earnings levels fairly quickly once the health crisis eases and the economy begins to return to some semblance of normalcy.
A conservative approach to helping protect against loan losses
Our outlook is rooted in our views on banks’ loan loss provisions—reserves set aside to cover future loan losses. While most loans continue to perform, loss provisions have become critical as banks allow customers to temporarily postpone or reduce loan payments—known as forbearance—and otherwise modify terms to temporarily alleviate customers’ current financial stress. As of late April, our tracking of first-quarter results showed that banks have been substantially expanding their reserves in anticipation that a certain percentage of borrowers won’t be able to meet debt obligations when the economy reopens.
The industry’s buildup in reserves has accelerated relative to reserve expansions in prior economic downturns because of a tightening of accounting standards; banks are required to provide for cumulative expected credit losses over the entire lives of loans on their balance sheets, rather than covering only for losses over the next 12 months. The Coronavirus Aid, Relief, and Economic Security Act—the initial government response to the economic crisis, best known as the CARES Act—allowed banks to opt out of the tightened accounting standard. However, according to our analysis of first-quarter reports through late April, all large banks indicated they had opted to not exercise the right to revert to the old standard. In maintaining the tighter standard, these banks have taken a hit to their short-term results, as they’re subtracting from current earnings in order to build up their balance sheet cushions more quickly than they could have done under the old standard.
In essence, banks are realizing credit expenses well in advance of when potential losses may actually occur.
Depending on the trajectory of the economy’s reopening from coronavirus-related restrictions, we believe banks are likely to continue adding to their reserves in coming quarters. If this trend materializes and the economy reverts to a growth track, we believe the buildup in reserves could actually help accelerate a recovery in bank earnings, as banks would have reserves in place to cover most expected future loan losses. In essence, banks are realizing credit expenses well in advance of when potential losses may actually occur. This is an important differentiator relative to recoveries from past economic downturns. Under old accounting standards, banks could spread the negative earnings impact from loan losses over longer periods.
Revenue and fee resiliency amid a crisis
In addition to building up their reserves, many banks have generated significant deposit and loan growth; initial first-quarter reports showed that banks reported stronger-than-expected loan growth of an average 7.3% relative to the same quarter a year earlier.1 These gains have largely been the result of corporate borrowers drawing down revolving lines of credit during a period of extreme market volatility in March. This extension of credit highlights the key systemic role that banks can play during periods of economic and market stress by helping to absorb shocks and meeting clients’ liquidity needs. Banks also benefit, as they can potentially generate profits from increasing their interest income when clients draw down revolving lines of credit.
As for revenue, banks’ initial first-quarter results came in better than expected, with operating revenue rising 4% from the same quarter a year earlier.1 We attribute this to several factors. For one, the steps that banks have taken to alleviate systemic shocks have returned loans and deposits to bank balance sheets. Known as reintermediation, this process supports banks’ net interest income. Consequently, it helps to offset some of the headwinds to banks’ net interest margins—a measure of a bank’s yield on interest-earning assets—resulting from recent interest-rate cuts.
Additionally, net interest income has been supported by interest-rate hedges that many banks implemented over the past year; for example, Citizens Financial Group and KeyCorp even raised their financial guidance for projected net interest income for this year’s second quarter, despite the headwinds from the recent rate cuts.2
Furthermore, our analysis shows that banks have recently maintained strong income from fees, supported primarily by two sources. First, mortgage banking revenue was strong over the first quarter as borrowers refinanced in the wake of the recent rate cuts. Some banks also commented that their mortgage pipelines remained strong—a factor that should support future fee income. Second, some larger banks reported increasing trading revenue related to strong capital markets activity given the spike in market volatility.
Positioned to ride out continued uncertainty
This revenue resiliency and the capital strength that’s evident from many banks’ balance sheets have allowed the industry to build up its reserves. Amid these changes, banks have largely remained profitable and, on quarterly conference calls, executives have expressed intentions to stand by the dividends that their banks issue, rather than reducing or suspending them. These factors have bolstered our expectations that banks may continue to serve as long-term value generators—despite the abundant headwinds they’ve recently faced—and will likely continue to confront to some degree amid continued uncertainty.
1 “KBW Bank Earnings Wrap-Up 1Q20, v. 2: Bank Results Continue to Reveal Unusual 1Q,” Keefe, Bruyette & Woods, April 24, 2020. 2 Bloomberg transcripts of first-quarter 2020 earnings conference calls by Citizens Financial Group, April 17, 2020; and KeyCorp, April 16, 2020.