State of the Banking Economy

Banks have been reporting moderate earnings for some quarters now and low return on equity rates compared to pre-crisis levels. Yesterday, the big U.S banks such as JP Morgan, Citi and Wells Fargo echoed this with their Q2 2017 earnings along with subdued guidance. Let’s look more behind these numbers and the banking industry to understand more of where the industry stands.

Many banks state the biggest drag is the low growth economy which has led central banks around the world to have low interest rate policies. Interest rates were slashed during the financial crisis to ward off a depression. Many central banks followed this with quantitative easing, which in essence also puts downward pressure on interest rates. The purpose of this was for banks to encourage more lending and thus lead to economic growth.

But have low interest rates led to more lending? Banks charge more for longer term borrowings than short term due to there being higher credit risk of repayment. Banks take advantage of this difference in rates by borrowing short and lending long. This net interest margin is a key profitability indicator for banks.

However, there has been an increasing demand for long term assets, mostly because investors are seeking safer and higher yields, which has put downward pressure on long term rates. This has resulted in a flattening of the yield curve, thereby narrowing the difference substantially between short and long-term rates. This reduces the banks’ net interest margins as thus there is less incentives for banks to lend at low rates for long term.

Misconduct has also burned through banks’ profitability. High pressure for banks to make money and misaligned incentive plans has led to poor culture within banks which often resulted in detrimental customer impact. The regulators have heavily punished these firms. Most of these were legacy issues dating pre-financial crisis but you shouldn’t be surprised to see more instances of misconduct especially as there is more pressure on profitability in this low interest rate environment for banks.

As we are in a 24-hour media frenzy environment, investigations by regulators of misconduct can have detrimental effects for banks. We only have to look at the impact of the U.S Department of Justice’s investigation of Deutsche Bank in 2016. A potential fine of $15 billion led to concerns of whether the bank has enough capital to withstand this and there were talks of even nationalising the bank to survive.

Banks have to hold adequate amounts of capital in relation to their risk weighted assets (RWA). The more riskier types of activity, e.g. trading book, means more capital needs to be set aside. This has led to banks revising their business models and shedding risker businesses and in riskier countries, in order to reduce their RWA’s and capital. Profitability has thus reduced as a result.

The challenger banks have fared relatively well. This is in large parts that they don’t have these legacy issues. In addition, they have embraced technology more than the bigger players and have avoided a lot of the operating costs.

We can expect low interest rates for some time yet. This will continue to put pressure on net interest margins and thus less appetite for banks to lend. The regulators have had a wakeup call since the financial crisis and have a more hands-on approach to supervising. This has led to more challenges to banks operations and riskier businesses which can continue to dampen profitability. It may seem that banks are becoming more as utilities. This may be a reason why the CEO of JP Morgan reacted very strongly against the politicians in order for them to do more on the fiscal side of things rather than shift everything on monetary policy, where it can be argued it has little effect on economic growth.

Dhallu & Co. and the author will not be liable for any reliance you place on the information in this publication. You should seek independent advice.

Dhallu & Co.