Mark Odendahl
Welcome to the Industries in Motion podcast from RBC Capital Markets, where we'll be exploring what's new and what's next in today's fast moving markets and industries, to help you stay ahead of the curve. Please listen to the end of this podcast for important disclaimers.
My name is Mark Odendahl and I am the Head of US Capital Markets research. Let's get into today's episode.
I'm joined today by Gerard Cassidy. Gerard is RBC’s Bank Strategist, as well as covers Large Cap banks. Gerard has been here for nearly three decades. Gerard is also the president and on the board of directors of BAAB. BAAB is the Bank Analysts Association of Boston. And it's also interesting to know that back in the 90s, Gerard was the creator of the Texas ratio, a ratio used by investors to determine whether a bank could be insolvent or not.
Gerard, welcome to the podcast.
Gerard Cassidy
Mark. It's a real pleasure to be here. And thank you for inviting me.
Mark Odendahl
So Gerard, over the last 18 months, we've had a bank cycle. How does that compare to the cycles that you've seen over your 30-year career?
Gerard Cassidy
Mark, this last cycle is unprecedented due to the activities and actions by the Federal Reserve and our US Federal Government. When you compare this cycle to the prior cycles, I went through the 1989/1990 cycle, the ’01/’02 cycle, and of course the one we all remember, the ’08/’09 cycle. And in those cycles, the bank stocks were devastated due to rapid credit deterioration. Normally, you get credit deterioration when the economy goes into a recession. So last year, as the economy plummeted, the actions by the Federal Reserve and the Federal Government were extraordinary. As we all recall, the Federal Government pumped trillions of dollars into the economy, and the Federal Reserve opened up its balance sheet to an unprecedented level. The outcomes of those actions was that the banks avoided a credit cycle.
The industry prepared for the credit losses at the start of last year by building up their loss reserves. In doing so, they damaged, of course, earnings in 2020. But as the year progressed and the economy came back so rapidly due to the Federal Government and Federal Reserve actions, the banks avoided the credit cycle, which is again unprecedented going back even years before I even started covering the industry.
So this one really was quite different than any other downturns we've experienced in my career over the last 30 plus years. And now as we look forward, we think the outlook is actually quite positive for the banks.
Mark Odendahl
You mentioned the industry avoided a credit cycle. Going forward, what do you think the drivers will be for shareholder returns?
Gerard Cassidy
It's going to be interesting because the recovery in earnings, kicking off in 2021, had been driven by what we've referred to as loan loss reserve releases. Once again, the industry set aside billions of dollars to handle the expected credit losses from the recession in 2020 – and didn't need to use them. So now they're putting them back into earnings, and earnings have been quite strong through the first six months of 2021. But we all know the earnings releases are almost one-time in nature. And they're going to fade away as we enter into 2022.
So it's going to come back to the core fundamentals for the banking industry. And the two biggest drivers for fundamental growth to drive shareholder value, over the next 18 to 24 months, will come from loan growth, and a steepening of the yield curve. These factors, obviously, have always been there for the banks, and have always recovered after those cycles that we've been through over the last 30 years. So we expect loan growth to come back. And we also expect to see a benefit or a tailwind from a better interest rate environment that we anticipate over the next 12 to 18 months.
Mark Odendahl
You've talked about a steepening yield curve and the possibility of higher short-term interest rates. You've also discussed this in a recent note that you published about interest rate sensitivity analysis around the top banks in the US. What does the report tell investors about the future profitability of the banks?
Gerard Cassidy
Market interest rates are very important to the profitability of the banking industry. It's the cost of their raw material, which is cash. And when you take a look at the current rate environment, the rates are very low, and banks are less profitable in a lower rate environment with a flatter yield curves. Therefore, a steepening curve would add to their profitability.
Now, as you may know, the long end of the curve is affected by a number of different factors. But most importantly, it's being impacted by the Federal Reserve's policy, their monetary policy of quantitative easing. And essentially what that is, is they're coming into the markets every month buying $120 billion of securities, $80 billion of governments and $40 billion of mortgage-backed securities. This is obviously creating excess demand, you could argue artificial demand, and as we all know, when demand exceeds supply, rates come down. We anticipate that, at some point in the future, the Fed will start to taper and what does that mean? That they'll scale back those $120 billion purchases to eventually zero. They've done this once before following the financial crisis. The expectation is that when the tapering ends, or during the tapering period, actually, long term interest rates will start to rise.
Should this take place, that will help benefit the bank's net interest margin, which is equivalent to a gross profit margin for an industrial company. So as the net interest margin rises due to a steepening curve, that will increase the revenue growth for the banks. And so we view this favorably and we anticipate that if the long end of the curve, over the next six to nine months, increases to 1.75% or 2%, you're likely to see a better margin for the industry, which will help their profitability.
Now banks are asset sensitive. And what that means is that the assets on their balance sheet will reprice faster than their funding costs. So in a rising rate environment through a steepening curve, you'll see better revenues coming from the banks as those assets reprice.
So think about it this way – all banks, of course, have securities portfolios. Every month, cashflows come out of that portfolio, those cashflows will be reinvested in higher rates in a steepening curve. Also, loans and other securities purchased will also have higher yields, which will again benefit this net interest margin.
Mark Odendahl
What do you tell investors on helping navigate the banks as interest rates move up? When is it time to further invest in the banks? Or when is it time to take profits?
Gerard Cassidy
That's a really critical question. Because when we look at interest rates, not only do we need to keep an eye on the steepening of the curve taking place through the long end of the curve moving up, but we also have to take a look at what's happening at the front end of the curve, which is directly controlled by the Federal Reserve's monetary policy. As you know, Fed Funds rates are essentially 0% today, which is the front end of the curve. And what we anticipate is that should the economy continue to grow as forecast by many economists, it's likely that the Fed will move on short-term interest rates. In fact, the Fed’s own policy has indicated they could raise rates as early as 2023. Some forecasters think it may come in the second half of 2022. If this does take place, the last two tightening cycles are a good guide on how investors should invest in bank stocks.
In the ’05/’07 tightening cycle and the 2016 to ’18 tightening cycle, what you saw was in those tightening cycles, bank stocks clearly outperformed the market. So in a rise in the short-term end of the curve through Fed Fund rates going higher, but stock should perform quite well. It's our estimate that you will own the bank stocks probably through three or four Fed Fund rate increases, and then at that point start to trim the stocks due to the fact that they tend to run out of gas. But boy, when the Fed starts to raise short-term interest rates, that would be quite positive for the bank stocks.
Mark Odendahl
So keeping all that in mind, how do you think about loan growth here?
Gerard Cassidy
Mark, that’s the number one question investors are asking us about the future of banking. Because the loan growth has not been positive, it's actually been negative. But when you look back at past cycles, this loan issue that we're seeing today is not unusual. And it takes some time for borrowers to start borrowing, again, whether it's corporates or individuals. Now, according to the Federal Reserve data that comes out every Friday afternoon, called the H8 data, the consumer loan growth has already picked up this year. So consumers are back borrowing. You're seeing it, of course, in auto loans, we're starting to finally see some credit card receivable growth, which of course, is very positive. The corporates and the commercial customers have yet to come back. And part of the reason is that there's a lot of liquidity on the corporate balance sheets today.
Now the liquidity is coming down, which is a good sign. There's also uncertainty about the future economic outlook. But the biggest, I think, headwind for commercial loan growth is the very low levels of inventories in this country. We all know about the supply chain issues, everybody sees it when they drive by their local car dealership, and you look at the parking lot, it's half empty. It's not just automobiles, where there's a shortage, it's everywhere. So as the inventories rebuild, we anticipate not only will companies be borrowing for capital expenditures, to build out plant and equipment, but to restock inventory. And if you look at the past two cycles, commercial loans are the last sector of the loan portfolio that does come back. But they do come back.
So we anticipate as the economy grows through the end of ’22, supply chain issues are ironed out and capital expenditures pick up. The banks will benefit not only from the consumer loan growth we're already seeing, but they're going to benefit from commercial loan growth over the next 12 to 18 months.
Mark Odendahl
Keeping in mind what you said about rates, and then what you also said about loan growth, what type of banks are going to do well in this environment?
Gerard Cassidy
I think it's going to be a varied benefit, depending on the bank's exposure to the different loan categories. So our so-called universal banks, those are our money center banks, these banks have a very diverse portfolio, they're very big consumer lenders, the credit cards, automobile loans, personal loans, all of this would benefit of course, in a stronger economy. So the universal banks benefit not only from the consumer loan growth, but also for the corporate and commercial loan growth.
Now the universal banks also have to fight the competition of the shadow banking industry, which is essentially the capital markets. So the capital markets are very, very robust. In fact, the debt capital markets had a record year last year in issuing paper. And so I would suggest that the universal banks will benefit, they may not receive as much benefit on the commercial side as the regional banks, but they certainly will benefit in the commercial area, but also the consumer.
You know, on the regional side, this is where the commercial benefit will be the best. Because the regional banks’ customers generally don't have as much access to the capital markets. And these regional banks will benefit as the economy comes back. Particularly, as you know, as the recent Census Bureau indicated, the real growth in this country is in the Southwest and the Eastern parts of this country. And so the banks that have presence there will probably see a bigger benefit from growth than the banks that are in the upper Midwest or in the Northeastern part of the United States.
Mark Odendahl
You just went over several positives for the banks. What are some of the risks to this bullish outlook?
Gerard Cassidy
There's always risks, as we know, as we saw with the start of the pandemic, which came out of left field for all investors. And so the biggest risk we foresee on the horizon is that this inflation issue is non-transitory, and it is not only persistent, but it starts to accelerate from where we are today. If that was to happen, the Fed would probably have to move more aggressively. And again, initially, when the Fed starts to raise Fed Fund rates, we have seen in the last two cycles, the ’05/’07 cycle, and then more recently in the 2016 to 2018 cycle, during those tightening cycles, the bank stocks did very well, for the first three or four Fed Funds rate increases, and we expect that to be the case again today.
However, if the Fed has to be more aggressive, and doesn't raise rates in a very methodical fashion of 25 basis points, every meeting, but they move at a 50 or 75 basis point increase, or they raise rates intra-meeting, which happened back in the 1970s and 80s, that would be problematic for the banks. So the one big risk we see on the horizon is that inflation gets out of control. It's not the base forecast. But that is the risk forecast.
Another risk, of course, not that we see this either, is should an unexpected recession arrive. That would be another issue. And though we didn't have the credit cycle in the last recession, there's always that risk that credit cycle could come back, and could come back stronger, because we avoided one in the last recession.
Mark Odendahl
What are some of the lasting impacts of the pandemic on the bank industry?
Gerard Cassidy
That's an interesting question, because some of the trends that had already started were accelerated during the pandemic. And probably the most lasting impact is the adoption of digital use by customers and banks. As we all know, the banking industry started with internet banking back in 2001. But it really didn't take off until the introduction in 2008/2009, of the iPhone. Since that time, digital banking has really taken off. And as many of us knew, as consumers of banks, we all use the access to our own personal accounts through the phone. And because of the pandemic, and due to the closures of branches and the stay at home orders, many people who were reluctant to move into the digital channel were forced to, so the adoption rates moved up quite meaningful. And in fact, Zelle, which is a p2p transfer mechanism, has now surpassed Venmo as the largest mover of money between consumers, and Zelle, the bank product was introduced in 2017, has quickly become the dominant transfer mechanism between consumers.
And so when we go forward, I think you're going to see an expansion of the digital channel, banks are investing heavily here, they're combating the fintech companies, who have a very narrow focus and are very good, but they just don't offer the breadth of products through the digital channel, which gives the commercial banks the advantage over the fintechs.
Mark Odendahl
So that investment in digital and other investments needed to compete. How is that driving M&A in the banking sector?
Gerard Cassidy
It's important, and it has been effective, no doubt about it. Since I've started covering the banks, we had, at the beginning of my career, over 18,000 banks in the United States. Today, we're down to about 5100. And so the consolidation over the last three decades has been immense. And it continues today, economies of scale have always been important for banking, and even more so today, because of the technological demands that the banks are confronted with to offer these products through the digital channel. Now, that doesn't mean we're going to say our banking industry in 10 or 15 or 20 years from now will have five or six banks. We do expect to see, amongst the top 20 or 30 banks, much more consolidation over the next 10 years, but in the end, we still have thousands of community banks in this country that are not publicly traded, they’re privately owned. In some parts of the country, we have what they call mutual savings banks, which are owned by the depositors.
But amongst the publicly traded banks, and to your point, I think this technology demand is going to be one of the catalysts to drive more consolidation. In fact, it was one of the biggest catalysts for one of the biggest mergers we've seen in the history of banking when SunTrust bank and BB&T merged, or announced their merger, back in February of 2019. So this technology demand is real, it's not going away, it's only getting bigger, which over time will be one of the catalysts to drive this consolidation further over the next five to 10 years.
Mark Odendahl
What other threats can you discuss to the traditional banking model?
Gerard Cassidy
I guess the biggest threat to the traditional banking model is the inclination of the biggest technology companies choosing to become bank holding companies. That's not likely. But there's always that possibility. And to obtain a banking charter as a non-bank, you need to create a bank holding company. And so the laws would have to change to allow this to happen. Also, the technology companies would have to see their multiples collapse ahead of time, so that absorbing or becoming a bank would not drag down their multiples. I don't foresee that happening anytime soon.
Now, the other threat is more regulation. Under the new administration, they're much more focused on bank regulation than under the past under the Trump administration. And so that would probably be the more immediate threat is that this administration focuses more on the Consumer Financial Protection Bureau, issuing more regulation to regulate the banks. So that would be the near-term threat. And when I say threat, it's not a threat that would derail the banking system. We're not going to see new regulation, like we saw coming out of the financial crisis, when we had the Dodd Frank bill introduced, which really transformed the industry. But there could be, around the edges, anticipated more regulation from the Consumer Financial Protection Bureau, as they try to level the playing field for customers of banks.
Mark Odendahl
Gerard, thank you very much. This has been a terrific rundown of the banking industry. It shows your decades of experience. Thank you very much for your time today.
Gerard Cassidy
My pleasure, Mark, thank you for inviting me.
Mark Odendahl
What else lies ahead in today's ever evolving markets and industries. We'll be keeping track right here on Industries in Motion. Until then, thank you for joining us on today's episode. Make sure you subscribe to Industries in Motion, wherever you listen to your podcasts. If you'd like to continue this conversation or are interested in more information, please contact your RBC representative directly or visit our website, which is www.rbccm.com/industriesinmotion for more insights, thank you.
Disclaimer
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