Loan growth rises while credit conditions stay benign

The median bank reported a return on equity (ROE) of 12.82% during the fourth quarter of 2022—1.75 percentage points higher than the year prior.¹ For the banking sector overall, loans grew 13% year over year, driving strong revenue growth with operating revenues 18% higher than a year earlier^.1 The combination of solid loan growth and an improved interest-rate environment pushed net interest margins higher. Net interest margins—the spread between what banks receive on interest for their loans and what they pay for their liabilities (deposits and other borrowings)—rose to 3.64% from 3.03% in the prior year’s final quarter,¹ showing the power of maintaining low-cost deposits in a higher interest-rate environment.

Credit costs have also remained low, with the median bank recording only 0.06% of net charge-offs as the sector continues to benefit from improved underwriting in the 15 years since the global financial crisis (GFC). On top of this fundamental strength, most banks tightened lending standards at the onset of the pandemic; they tightened further in 2022 as the U.S. Federal Reserve (Fed) began to raise interest rates and recessionary fears started to build.

Recession risks persist, but banks appear to be well prepared

Despite these fundamental strengths, we believe that bank management teams recognize the possibility of a recession as the Fed tightens monetary policy in an effort to curb inflation. As we anticipated, banks have taken a conservative approach by beginning to build loan loss reserves to protect against an economic downturn. These increased reserves could be used to absorb future credit costs if the economy deteriorates. Adding such reserves does come at a cost, as it drags on current quarterly earnings; however, if the economic environment remains healthy, banks could then release these reserves, benefiting earnings in future quarters.

U.S. bank equity valuations remain attractive

Overall, we believe the sector remains healthy. Despite this, bank stocks have recently traded at historically attractive levels. As of February 17, 2023, the S&P Composite 1500 Banks Index was trading at a price-to-earnings multiple of only 10.1x, which is more than one standard deviation below its historical discount relative to the S&P Composite 1500 Index dating to the mid-1990s^.2 On a price-to-book basis, banks were trading at 1.13x versus a long-term average of 1.59x^.2

Source: FactSet, 2023. The forward price-to-earnings (P/E) ratio is a stock valuation measure comparing the current share price of a stock with the underlying company’s estimated earnings per share over the next 12months. Standard deviation is a statistical measure of the historic volatility of a portfolio or an investment index. It measures the fluctuation of periodic returns from the mean or average. The larger the deviation, the larger the standard deviation and the higher the risk. The S&P Composite 1500 Banks Index tracks the performance of publicly traded large- and mid-cap banking companies in the United States. The S&P Composite 1500 Index tracks the performance of publicly traded large- and mid-cap companies in the United States. It is not possible to invest directly in an index. Recession periods indicated are as defined by the National Bureau of Economic Research. Past performance does not guarantee future results.

Banks’ funding advantage has returned

One of the main competitive advantages of a bank is its access to insured deposits, which banks use to make loans to customers. These deposits provide a stable funding source versus having to rely on capital markets, which can be volatile. Historically, this stable funding source has generally come at a low cost, which gives banks a sustainable advantage over other non-bank financial institutions. Of course, access to these low-cost deposits doesn’t come free: Banks are subject to stringent oversight, regulatory costs, and capital requirements, all of which intensified in the years following the GFC.

When we take the federal funds rate—a proxy for what a nondepository institution would pay for funding—and subtract the average cost of deposits for the banking industry over three different periods, we see a strong upward lift to banks’ funding advantage. In the period from 1992 to 2007, this advantage was over 1% on average relative to non-bank institutions. From the end of the GFC in 2009 up to 2021, as certain costs and regulatory requirements increased, the Fed’s zero interest-rate policy (in place for most of this time) largely eliminated this advantage.

In 2022, as the interest-rate environment normalized, this advantage returned with a bang. Throughout the year, banks on average benefited from a more than 2.5% funding advantage relative to non-banking institutions. This was one of the main drivers behind banks’ ability to achieve an improved ROE of nearly 13% in the fourth quarter. 

Moreover, it appears that this advantage should persist as the Fed has recently indicated that it’s likely to leave interest rates higher for longer. We expect that this funding advantage is likely to serve as a long-term positive for the sector, as it will help banks sustain their improving ROE. 

1 “KBW Bank Earnings Wrap-Up 4Q 2022, Final Ed, A Tale of Two Earnings Seasons: LC Banks Outperform As SMIDs Lag,” Keefe, Bruyette & Woods, February 2, 2023. 2 FactSet, 2023.