This too shall pass – Despite market turmoil, the US banking industry remains fundamentally sound

The heightened price volatility among bank stocks has been excessive due to investors taking an extremely bearish view of the health of the economy. This sentiment is related to a sequence of historical events, including the US Federal Reserve’s (Fed) 50 basis point (bps) emergency intra-meeting cut to the Federal Funds Rate on 4 March, and the accelerating global spread of COVID-19. Another shock was felt by the oil market when Saudi Arabia ushered in a new price war with Russia – a move that saw it increase production and slash export prices. These events drove risk-off sentiment throughout the market leading to a dramatic flight to safety, evidenced by the 10-year US Treasury bonds at one point yielding a historic low¹.

Further selling pressure on US bank stocks was driven by the Fed’s second emergency announcement on Sunday, 15 March, which included a 100bps cut to the Federal Funds Rate and a new bond-purchase agreement worth “at least” U$700 billion.

Soon after, eight of the country’s largest banks, which are represented by the Financial Services Forum, said they would pause share-buyback activity through the second quarter of 2020. 

In a press release, the Financial Services Forum noted: “The decision on buybacks is consistent with our collective objective to use our significant capital and liquidity to provide maximum support to individuals, small businesses, and the broader economy through lending and other important services. The decision is consistent with actions by the US Federal Reserve, the administration, and the Congress.”²

As a result of these events, valuations in the financial sector, and specifically the banking industry, have reached extreme levels that diverge from underlying fundamentals. At the time of writing, the SNL Bank Index is trading at 86% of book value. (Chart 1) The last time banks traded below book value was during the global financial crisis, as well as in 2011 when US government debt was downgraded.³

Given previous declines of this magnitude were only seen during the global financial crisis, it is important to note that the fundamentals of the banking industry today are remarkably improved. 

• Capital is robust: When we entered the global financial crisis, bank capital was materially lower than it is today. As at 31 December, 2007, tangible equity, as a percentage of tangible assets, measured 7.0% versus a more robust level of 9.4% in 2020.⁵ (Chart 2) This higher level of capital provides a larger buffer against any downturn.
• Liquidity is strong: Following the financial crisis, bank regulators implemented the Liquidity Coverage Ratio (LCR) for the biggest banks in the country. The LCR requires banks to hold higher on-balance sheet liquidity. It also measures a bank’s ability to self-fund its cash needs over a 30-day period, assuming capital markets remain closed. This buffer is designed to ensure we will not see the liquidity runs that were present during the height of the global financial crisis in 2008.
• Bank balance sheets are regularly stress tested: Before the global financial crisis, the balance sheets of US banks were not regularly stress-tested by regulators. As a result, investors did not have the same insight into the health of the banking system that we have today. Now, the Fed performs a stress test of the largest US banks during its annual CCAR process. Each year, the stress tests evaluate a different set of economic variables with severe assumptions. For example, in the 2019 stress test, the Fed assumed a rise in the unemployment rate to 10% and an 8.5% contraction in GDP. In other periods the stress test assumed that interest rates had turned negative. To successfully pass the evaluation, banks must maintain adequate capital levels over a two-year period, sustain their current dividend, and continue to buyback stocks during the downturn. These stress tests give us comfort that US banks are adequately equipped for a severe economic decline and their dividends are secure. This stands in stark contrast to the first set of results in 2009, which showed that US banks had a $75 billion capital shortfall.

While a zero-interest-rate policy is not ideal, banks did operate very profitably following the global financial crisis when a zero-interest-rate environment lasted from December 2008 to December 2015. Although the latest cuts will undoubtedly put pressure on banks’ net-interest income over the medium term, the most recent monetary stimulus should help the economy when we move past the disruptions caused by COVID-19. Importantly, during the press conference following the Fed’s announcement, Chairman Jay Powell stated that they do not expect to utilise negative rates. To ensure that credit markets are functioning correctly, we expect to see more bond purchases. These should be similar in nature to the quantitative easing rounds that came in the wake of the financial crisis.

We would also note that the Fed is encouraging banks to utilise the discount window so they can continue to support households and businesses. Over the next few days, the largest banks will tap the discount window to remove some of the stigma around its use. However, we anticipate more limited use over the longer term, as US banks have plenty of capital and liquidity already in place on their balance sheets to support customers as we go through this period.

Given the strength of the banking system today, we believe that banks will provide support to the US economy as corporations and business owners work through this global health crisis and potential economic slowdown. Banks have ample liquidity and capital to lend and can support borrowers who may experience temporary business interruptions. As at 31 December 31, 2019, the loan-to-deposit ratio for the US banking industry stood at less than 80%. This provides banks with plenty of liquidity to lend to customers during these tumultuous times. Additionally, select banks have indicated that deposit inflows have been strong, as customers seek safety due to the increased volatility in markets.

Following other natural disasters, banks regularly provide capital to customers whose businesses are disrupted, and there is a need to rebuild. A recent example was the September 2017 hurricane that impacted Puerto Rico. Although economic activity was halted due to a complete shutdown of the island’s power grid, banks on the island experienced only slight increases in non-performing assets. As such, we expect banks to provide similar support to their customers during the current unsettled period. 

Furthermore, on 9 March, the Fed issued a statement directing banks in this regard.⁶ While mostly a symbolic press release, the announcement will eliminate some regulatory scrutiny on banks as they work with borrowers facing temporary stresses. It will also increase the availability of credit to help dampen any adverse economic effects. 

We have already started to see US banks act, a regional bank headquartered in Massachusetts, recently announced a comprehensive support programme to help its customers with potential financial struggles related to the impact of COVID-19. The plan will take effect on 18 March for an initial 30-day period and provides several additional services for retail banking, consumer loan, mortgage, and small business customers.

In terms of bank earnings, we expect the next few quarters to be choppy. In the short term, banks will build loan-loss reserves for potential credit losses that may result from an economic slowdown. Additionally, the lower interest-rate environment will put some pressure on banks’ net-interest income. On the other hand, banks with mortgage banking businesses will benefit from a wave of refinancing activity in the next quarter or two. We expect that banks will return capital to shareholders in the form of dividends, as well as continue to demonstrate their ability to compound book value over time.

We cannot say for sure when stock prices will rebound; however, we believe the US banking industry is fundamentally sound, and valuations are significantly depressed. In comparable periods before, when bank stocks traded at trough multiples, the market dislocation proved to be transitory and historically a very attractive entry point for long-term investors.

1. Bloomberg, 9 March 2020. Intra-day low is 0.3137% on 9 Mar 2020. 
2. Separately, US Bancorp (USB) also announced it would join these banks and suspend its buyback activity.
3. Data from S&P Market Intelligence, March 16, 2020
4. SNL Financial, 12 March 2020, US dollar.
5. FDIC, 31 December 2019.
6. Federal Reserve, 9 March 2020.

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