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HomeTOP TRENDSA Mixed Outlook? The Banking Sector and Its Three Key Drivers

A Mixed Outlook? The Banking Sector and Its Three Key Drivers

The latest earnings results for banks include words like “record,” “outstanding,” and “doubles.” So far, 2023 has been a banner year for the sector, at least from an earnings perspective.

But bank stock prices have yet to eclipse their previous highs. The KBW NASDAQ Global Bank Index, which tracks global banks, has barely grown since the current rate-hiking cycle began in early 2022 and generally has not exceeded its pre-COVID-19 peaks. Other bank indexes haven’t outperformed either. The S&P Regional banks index is trading at 2016 levels.

Banking is a complex sector with many influences. So, to understand the mid- to long-term outlook, we need to understand the three key drivers at work in the industry today.

The US Federal Reserve’s hiking cycle has been the fastest in decades, and the banking sector has profited from it. As rates rise, a bank’s assets tend to reprice faster than its liabilities and thus a bank’s net interest income, which constitutes the bulk of its earnings, increases. That is what has happened in the current rate cycle, which has created a tailwind for the industry’s financials.

But higher interest rates are a double-edged sword. Many banks loaded up on sizable portfolios of long-duration securities during the easy money era, and their prices have plunged as rates have risen. Held-to-maturity — or hide-’til-maturity — accounting has shielded bank financials from the impact, but should these portfolios be unwound, the losses will materialize and the bank’s capital will take a hit. This is a sector-wide concern, as W. Blake Marsh and Brendan Laliberte observe in “The Implications of Unrealized Losses for Banks.”

Indeed, the switchover from a low or negative rate environment to one with a positive but inverted yield curve occurred quite quickly. Could this spell trouble for banks? According to financial theory, banks engage in term transformation — they borrow in the short term to lend over the long term — so the answer to the question may very well be yes, theoretically. But in practice, banks borrow and lend at different points on the curve, and the average maturities of loans and securities tend to be below five years. Additionally, assets and liabilities are well matched, so the banks may still make money with an inverted yield curve. In fact, in “How Have Banks Responded to Changes in the Yield Curve?” Thomas King and Jonathan Yu find evidence that banks actually increase their net interest margin with a flat curve.

Neobanks and fintechs are the offspring of low rates and technological disruption. Low rates forced banks to look for alternative sources of income amid historically low spreads on their bread-and-butter products, which meant charging higher fees for credit cards, cash transfers, etc., to generate non-interest income. This combined with old technology stacks and start-ups financed with cheap money created fierce competition for traditional banks. That is, until the fintech winter settled in.

With easy financing rounds a thing of the past, most neobanks will have trouble surviving. The vast majority have yet to achieve profitability, and they won’t have cheap funding to fill the gap any longer. Moreover, as banks revitalize their reliance on conventional sources of revenue — interest income — the pressure to increase service fees will fall. For all the hype about customer experience and digital disruption, neobanks will have a hard time retaining customers if their fees are more or less the same as traditional banks. Some banks may even be tempted to go on the offensive and cut their commissions now that their interest income offers a financial cushion.

So, how are the market variables moving for banks? Not very well. The sector is still underpriced relative to other industries. Price-to-book is banking’s universal multiple, and many banks are still below the magic value of 1. There are several reasons for this. Even though earnings are improving, clouds are gathering on the horizon. Unilateral government action through direct taxes as in Italy, increased regulation, and additional capital requirements are all possibilities. Bank compliance departments are growing ever larger and constituting an ever greater drag on profitability.

A further headwind is the unrealized losses on securities portfolios. How large are they? Large enough to trigger a liquidity event? We don’t know, and that poses an additional risk for the sector.

New production — slower credit growth due to tighter conditions and a deteriorating economy — is another challenge. Germany and Holland are already in technical recession, and whether the United States can avoid one in a higher rate environment is unclear. The latest GDP readings have been robust, and the labor market is resilient, which helps explain why US banks trade at a higher price-to-book ratio than their more-subdued European peers. But even in the United States, credit card and auto loan delinquency rates have started to swing upwards, and the housing market’s outlook appears cloudier the longer rates stay elevated.

The banking sector is in better shape now than during the last decade of low or negative rates. The fintech winter will ease competitive pressure and give some banks the opportunity to buy out neobanks and appropriate their technology stack. However, latent losses in banks’ securities portfolios, the political temptation to overtax and overregulate the sector, and the damage higher rates may inflict on the economy could take a toll on an otherwise bullish outlook.

So, the next few quarters should present both considerable challenges and opportunities.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / sakchai vongsasiripat

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