US Banks: The years of plenty are over – we reduce risk
As the majority of US banks have now published their quarterly results, we provide our view on US financial institutions in light of the latest developments in interest rates. We focus particularly on the impact on net interest income given that bank earnings heavily rely on the lending business.1
The 10-year US Treasury yield has recently declined at considerable speed and more than halved since reaching a local high back in autumn 2018 (3.23%), currently standing at 1.56%. Yield curves have continued to flatten; in fact, many important segments of the curve have actually inverted. The current environment presents a challenge for banks given the nature of the lending business as the net interest margin depends on both the absolute level of interest rates and the term structure. Due to the sharp decline in interest rates, it comes as no surprise that US banks had to contend with falling interest margins in the second quarter of 2019, as Figure 1 shows. The net interest margin has thus receded to the previous year’s level; however, there is one key difference in the economic environment: At the beginning of 2018, the market still expected a series of rate hikes from the Fed, while the opposite is now the case. Following the 25 basis point rate cut in July 2019, the Fed is expected to cut interest rates by a further 66 basis points by the end of the year.
Figure 1: Net interest margin of the 25 largest US banks (%)
Source: SNL, Barclays Research (excluding investment banks Morgan Stanley and Goldman Sachs)
Figure 2: Net interest income of the 25 largest US banks (USD billion)
Source: SNL, Barclays Research (excluding investment banks Morgan Stanley and Goldman Sachs)
Despite this challenge, banks managed to earn stable net interest income in the second quarter of 2019 (Figure 2), but that was almost exclusively driven by loan growth. In fact, the Fed’s latest Senior Loan Officer Survey confirms that lending standards have moved back into easing territory. The driving force behind the movement in the overall indicator is the “Commercial & Industrial Loans” component (see Figure 3). This sub-index is an important leading indicator for US high yield default rates. Furthermore, in the past, it has exhibited a strong correlation with corporate investment activity in the US. Even though the signal has not moved far from the neutral line and uncertainty caused by the trade conflict has depressed capex spending, we believe that looser financing terms can have a positive effect on the financial situation of US high yield companies.
Figure 3: Net % of US banks tightening lending standards on C&I loans
Average of lending standards to large and middle market and small size firms. Negative value equals loosening standards
Source: Federal Reserve Senior Loan Officer Survey, BEA, CreditSights
On the other hand, a looser financing environment may not be as positive for banks. Importantly, the situation must be regarded from the point of view of credit quality and capitalisation. At the moment, we are still observing positive developments on this front. However, it might be a matter of time until competition in loan origination intensifies and interest margins fall further. Should this happen, banks could be tempted to take on more risk in terms of credit quality. If so, in subsequent years, losses on non-performing loans would likely increase, weakening both the profitability and capitalisation of banks. Even though such a dynamic typically develops gradually over time, the question is whether compensation for the inherent risk in bank bonds is currently adequate. Figure 4 shows the risk premia (option-adjusted spread, OAS) of US banks versus the US Investment Grade Index. Bank bonds tend to have a slightly lower risk premium than the overall index, as the duration of bank bonds at 5.8 years is almost two years shorter than that of the overall index, which currently is at 7.6 years.
Figure 4: Risk premia (OAS) of the US banking sector vs US Investment Grade Index
Source: Bloomberg, Ice BofAML
Since the beginning of the year, US bank bonds have performed better than the wider index, with US bank spreads tightening more than 10 basis more than the benchmark spread. This stands in stark contrast to equity markets as US banks in the S&P 500 Index have lagged more than 7 percentage points versus the overall index since the beginning of the year (see Figure 5).
Figure 5: Performance of S&P 500 banking index vs S&P 500
Source: Bloomberg
To be clear, we still regard the fundamental position of US banks as much better than that of banks in Europe and Japan. Additionally, a decline in net interest margin and an increase in net charge offs on non-performing loans can be mitigated by other earnings sources, such as capital markets, advisory and the typically less cyclical fee income. However, it is worth keeping in mind that some of the capital market related earnings sources are also drying up at the moment. In view of current valuations, we are reducing our overweight in US banks to an underweight in the Global Corporates strategy, bringing our position in US banks in line with the rest of the banking sector. Overall, we continue to favour defensive sectors, such as healthcare and the telecoms and media sector.
155% of the earnings of the 25 largest US banks (excluding investment banks Morgan Stanley and Goldman Sachs) come from net interest income, with the remainder derived from non-interest income (e.g. capital markets, asset management and fee business)