Three ways the banks will be winners from Covid recovery
Business cycle and interest rates look to be lining up to lift the sector’s fortunes
Banks are regarded with a certain awe for both their role as gatekeepers of the economy and the bonuses bankers pull in at year-end. But there is an irony here: more than any other industry, banks and bankers are hostages to fortune. Their profits are bound to the business cycle and interest rates.
Both factors may be lining up to lift banks’ fortunes now, however. A week ago, news that Pfizer’s Covid-19 vaccine was effective pushed the drugmaker’s shares up 7.7 per cent — and bank shares up 13 per cent. This tells you how sensitive banks are to an economic recovery from the pandemic.
Should we put the virus behind us, banks will benefit in three ways.
Long-term interest rates are likely to nudge upwards as business activity picks up. As the US Federal Reserve is committed to keeping short rates at zero, this would lead to higher bank profits. This is because banks fund themselves at the short end of the market and lend at longer-term interest rates. Even stabilisation at the long end, as opposed to further declines, would materially help bank profits.
Then there is the $112bn that US banks have set aside for loan losses since the pandemic began. Given that the losses have not materialised yet, much of that could flow back through bank income statements, becoming profit.
Finally, banks’ revenues would start to rise, as demand for loans increased. For example: the stock of credit card loans at US banks has fallen by $100bn, to $755bn, since the crisis began, as consumers cautiously put away their cards. These loans, with their high interest rates, are a key profit driver for the largest banks and are all but certain to come roaring back when the country has been immunised. And commercial lending demand would bounce not long after consumers revived.
Last Monday’s rally did not price in a full recovery. Not even close. Bank indices remain more than 20 per cent lower than in February, even as the wider market is above where it was. If you think that the vaccine is going to work, investing in banks is the obvious trade, and it should have plenty of gas left in the tank.
Why, then, have bank shares mostly drooped or traded flat since last Monday? Investors are staring at interlocking medical and political uncertainty. Vaccines will take time to roll out and anyone who has followed the biotech industry knows that when a new product goes to a big population, there are often surprises.
In the meantime, Covid-19 cases are surging to all-time highs in the US and municipalities are starting to reassert restrictions on economic activity. In response, Congress has been signalling uncertainty over stimulus spending. If this continues, the country could dip back into recession in the first quarter and banks could see loan defaults before the vaccine can ride to the rescue.
It is hard to assess how vulnerable loan books are: banks’ disclosures are complex and often idiosyncratic.
Take Key Bank, a big regional bank based in Ohio (a good example because its disclosures are particularly thorough). In the third quarter, it said that of its $104bn in loans, less than 2 per cent were in forbearance — that is, not paying because of Covid-19 and put into suspended animation as permitted under the US bailout law, the Cares Act. That’s less than half the level of the second quarter. That sounds encouraging.
But the bank also discloses that it has modified the terms on $5bn in loans hit by Covid, but not classified most of them as restructured or distressed (as the Cares Act also allows). That’s a significant number; the bank has only put aside about $1bn in new loss reserves since the crisis began. How many of those are at risk, under the double-dip scenario? Hard to say.
If you think the double-dip can be avoided, though, the good news for banks should come quickly. As veteran analyst Charles Peabody of Portales Partners points out, if a stimulus does come through and a vaccine looks imminent, banks will have little choice but to start to release significant amounts of reserves, revving up profits.
This is because a new accounting rule, known as CECL, requires banks to set reserves according to anticipated losses over the whole life of a loan, rather than over the present accounting period.
So banks must look out two or three years into the future. If the virus appears set to abate within that time period, they have no choice but to bring reserves down (just as at the start of the crisis, they had no choice but to raise them drastically). And falling reserves will send the market a very positive message.
This is an unusually uncertain moment in America. Banks offer one way for optimists to bet that the dismal tide is about to turn.