The COVID-19 pandemic has triggered a reversal of interest rate hikes in the US, which directly weighs down on banking profit expectations. The deteriorating economic outlook has also triggered provisions for loan losses that overshadowed the bank’s performance in the first quarter and raises concerns for second quarter build up. Nonetheless, unlike the financial crisis of 2008, when banks were in the midst of the housing crisis, US banks in the COVID-19 world are well capitalised and are currently part of the solution: managing the cash crunch created by the temporary closure of businesses.
The zero-interest rate level is a clear and material headwind to the bank’s profitability. During the first quarter, the US Federal Reserve slashed the target federal funds by 150 basis points to the 0 per cent to 0.25 per cent level and communicated expectations for the rates to remain anchored at zero until 2022.
Banks fund longer term loans with shorter term deposits and the subsequent lower interest rate outlook has led to a flatter yield curve. The spread compression is expected to deteriorate the Net Interest Income (NII), which represents the difference between the interest rate charged on loans and the rate paid on deposits. As long as rates remain zero bound, the NII is expected to remain under pressure, most especially for banks which have a higher interest rate sensitivity, such as Bank of America.
In the short term, the decline in NII is expected to be partially offset by stronger trading revenue, on the back of a period of high volatility and a surge of trading volumes. The market recovery since the lows of March should also support higher fee income across wealth and asset management as total value of assets under management recover. However, merger and acquisition activity is expected to remain subdued as long as the economic outlook remains challenging. Needless to say, banks with a higher exposure to capital markets are more likely to cushion their next quarter’s earnings results by higher fee income.
The slowdown in economic growth and rise in unemployment numbers also raises concerns about the ability of firms and households to meet their payments. From the banks’ point of view, this increases the probability of higher credit losses and called for higher loan loss provisions. In other words, banks increased the amount expensed to cover for future uncollected loans and loan payments. In the first quarter, the six largest US banks collectively allocated an addition of $25.4 billion to loan loss reserves. JP Morgan and Citigroup reported the highest reserve ratios among the largest peers. The difference in amount of loan loss provisions is underpinned by the banks’ economic expectations and more importantly reflects the loan and client mix of each individual bank. For instance, Citigroup’s reserve ratio reflects its higher card concentration.
In this respect, the banking industry has played a pivotal role during the pandemic by offering interest payment deferrals. The government stimulus targeted at both individuals and businesses, together with the bank deferrals, are expected to help mitigate future credit losses. Nevertheless, an upward move in non-performing loans signals that charge-offs are expected to increase in the short term.
On a positive note, the recent decline in volume of customers asking for forbearance relative to the high points in March and April is an encouraging industry wide trend across large US banks. Case in point, management at Bank of America have guided that the volumes of deferrals have since fallen from peak levels while JP Morgan noted most requests were more of as a safety precaution amidst a period of severe uncertainty.
More importantly, US banks have entered this crisis better capitalised relative to the previous one. This implies that the current industry headwinds point to earnings issues rather than balance sheet concerns. On this note, as long as interest rate expectations remain subdued, US banks are expected to recover some of the lost profitability in a post COVID-19 environment, when credit costs decline and reserves can be reversed.
Disclaimer: This article was issued by Rachel Meilak, CFA equity analyst at Calamatta Cuschieri. For more information visit www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.