In stark contrast to the financial crisis of 2007-2009, the banking sector has shown solid strength through the Covid driven market crisis.
During the financial crisis most of the U.S. banking sector was saddled with bad loans, low liquidity and a paucity of equity. Today’s banking sector has excess capital, strong credit results and a massive excess of liquidity. We attribute today’s strength to the success of the regulatory measures placed on the banks post the financial crisis, which mandated building capital to strong levels, increasing reserves and preventing dividends and buybacks until these levels were achieved.
The federal regulation to strengthen banks post the financial crisis worked so successfully, that the banks played a major role in helping the U.S. economy to avoid sliding into a recession due to the Covid crisis. Large banks helped the Fed to administer the Fed’s loan facilities and both large and small banks stepped in to deliver Payment Protection Program (PPP) loans. The regulators got it right.
Looking forward, we think investors remain too negative on the banking sector as a whole and believe there are several levers that can drive bank earnings higher over 2021 and beyond.
1) The fear of increasing credit losses appears to be mitigated by the significant liquidity and stimulus actions from the U.S. government that have helped affected business survive the shock of lockdowns. As Covid restrictions ease, these businesses should recover earnings and return to normal debt service activities.
2) As the economy in general strengthens, loan demand should accelerate, which is a positive for banks looking to lend their excess capital.
3) With the rising yield on the 10-year treasury, spread income for banks should increase, as the U.S. Federal Reserve continues to hold Fed Funds short rates near zero for the foreseeable future.
4) Most leading banks are aggressively deploying their information technology investments to digitalization strategies that are helping to reduce costs and improve efficiency ratios.
5) With strong regulatory results under the Federal Reserve’s CCAR reviews again for 2020, many banks have resumed balance sheet deployment strategies, which include both share repurchases and acquisitions. Share repurchase benefits will likely be felt in both open market price support and improved return on equity (ROE) results for banks, as equity levels stabilize while earnings grow. (We note, the impact of buybacks on shareholder equity levels is one of the main reasons we prefer to look at the retained earnings line item when analyzing book value growth). Banking acquisition activity can be a strong source of earnings growth, due to both the expense savings consolidation brings and the ability to jumpstart growth into new geographies vs. slower de novo branch opening activities.
In summary, we see valuations for many banks as compelling, trading at or under book value, healthy dividend yields over 3% and price earnings multiples around 10x-12x. While we have our favorites that we own for clients, we think the group in general looks well positioned to outperform.