The past few weeks have seen growing investor concerns on banks, including of US banks. This contrasts with the excellent year, the banking sector had in 2015 in terms of profits and its better capitalisation and higher liquidity reserves than before the crisis. What accounts for these concerns? Two fears are being voiced: (1) investors are increasingly sceptical of the banks’ capacity to generate earnings in the future and (2) doubts about the quality of bank balance sheets are multiplying.
The profits of US banks under pressure
US banks just wrapped up an exceptional year in terms of profits. The combined net income of the eight largest banking institutions (JPMorgan Chase, Bank of America, Wells Fargo, Goldman Sachs, Citigroup, Morgan Stanley, State Street and Bank of New York Mellon) was more than $90bn in 2015. Nonetheless, investors expect the overall profitability of banks to deteriorate. It is important to understand that these record-setting profits were fuelled in recent years by:
However, the benefit of these cyclical factors is expected to fade in the coming quarters and the environment has definitely become less favourable for earnings growth.
Regulations and the protracted low interest rate environment are adversely affecting the growth prospects of banks. Investors are well aware that the cost-cutting strategy adopted by most financial institutions is not a long-term solution.
Loans to households: car and student loans are at risk
The post-Lehman economic recovery has seen a drastic reduction in household debt helped by the explosion of mortgage defaults in the subprime segment. Defaults on outstanding consumer loans have also risen to high levels. Household debt as a percentage of available income reached a record low of 135% in September 2013 after a peak of 110% at the end of 2007. The pace of growth of household debt has been relatively slow since. Should we conclude US banks and households have adopted virtuous conduct and that we shouldn't be overly concerned about them? The devil is definitely in the details. Although the risks remain relatively low in mortgage lending, the situation is more acute for student and car loans.
Loans to businesses: the Achilles heel of the US economy
Unlike households, the debt level of US businesses has grown sharply, reaching a 10-year high in late 2015. US companies have benefited greatly from the Fed’s ultra-accommodative monetary policy. Companies have raised record amounts of cash on the financial markets and from banks, mainly to finance M&As and asset buybacks, to the detriment of investment (See Cross Asset Investment Strategy - December 2015 “The huge increase of US corporate debt makes the Fed’s game more complicated”). Given the current high level of corporate debt, lower profits could do great harm if they trigger an increase in the number of defaults. Profit growth is a source of concern:
The direct effects are not necessarily the most worrisome. In and of themselves, the difficulties in the energy sector should not do much damage to the balance sheets of the big banks. The second-round effects are more worrisome even if they are difficult to assess. For instance, the weakness of US states that depend on oil could affect the quality of consumer, real estate or commercial loan portfolios. Lower personal income could translate into growing challenge for households to repay auto loans. We could then face a third-round effect: deterioration of bank balance sheets due to tighter financing conditions across the entire economy. High corporate debt in the US may grease the wheels for a domino effect.
The US economy is being hurt by the energy sector and, more broadly, by the manufacturing sector (20% of GDP). One vector for the transmission to the economy as a whole could be across the board tightening of financing conditions. But this trend, if it materialises at all, will take time.
The low interest rate environment is a drain
US corporate debt ratios have grown considerably since 2012, reaching their highest levels in a decade