Banks struggle to persuade investors (and regulators) that better times lie ahead

The release of third-quarter results from US Main Street banks JP Morgan Chase and Citigroup on Tuesday 13th October and then Bank of America and Wells Fargo on the 14th will be important both as the starting point for America’s third-quarter reporting season and a precursor for the results that are due from the FTSE 100’s Big Five banks at the end of the month.

A leap in provisions for bad loans, and an associated plunge in profitability at the big four American banks, in Q1 and Q2 forewarned of tough times at the UK market’s biggest lenders, who saw first half profits fall 78% year-on-year and even slipped into loss between them between April and June. The same combination of recession, rising bad loans and pressure on lending margins took a toll on both sides of the Atlantic.

Source: Company accounts

Analysts and investors will therefore be hoping for an improved showing in the third quarter, when the US and UK economies tentatively emerged from lockdown and – in the case of HSBC and Standard Chartered – Asia began to show some renewed momentum.

Provisions for sour loans reached $33 billion in Q2 in total across Bank of America, Citigroup, JP Morgan Chase and Wells Fargo, the highest figure since Q3 2009 and the end of the Great Financial Crisis. That punctured their profit and loss accounts, as combined net income fell 75% year-on-year to $6.8 billion between April and June.

Source: Company accounts

However, the combination of a recovery in the US economy and the assumption that the banks accounted conservatively in the first half of the year means that analysts are expecting a big rebound in net profits at the Big Four Main Street banks, to $13.3 billion in Q3 before a slight slip back to $12 billion in Q4. That will still leave profits down by almost half year-on-year in Q3 and Q4 but consensus forecasts are looking for a big surge in bank earnings in 2021, albeit to nothing like the level reached in 2019.

Source: Company accounts, Zack’s, analysts’ consensus forecasts

The forecast rebound in US bank earnings does not rest solely upon bad loan provisions (or the lack of them). Citi, JP Morgan Chase and Bank of America have substantial investment banking businesses which could be making hay, thanks for rampant bond issuance, a resurgence in merger and acquisition (M&A) activity and a bubbly market for new company listings, not forgetting wider day-to-day volatility in secondary equity markets.

It will also be interesting to see if loan books start to expand again after a dash into cash from customers in the first half of 2020: deposits across the US Big Four rose 20% year-on-year to $6.3 trillion while loan books advanced by just 1% to $3.6 trillion in the second quarter.

Moreover, the US banks will want to make an improved return on any new loans. Record-low interest rates and the US Federal Reserve’s efforts to crush the yield curve and suppress bond yields via its Quantitative Easing (QE) programme have hammered net interest margins at the US banks and thus hit profits hard. The Fed seems keen to avoid a move toward negative interest rates – the San Francisco Fed has even just published a paper to highlight what it sees as the folly of such a policy, arguing it has done more harm than good in both Europe and Japan. Even so, a rate hike seems a long time away, as do any moves to sterilise QE by shrinking the Fed’s $7 trillion asset base.

The average net interest margin across America’s Big Four has dropped to 2.05% from 2.54% since Q2 2017. While a 49 basis point (0.49 percentage point) fall may not sound a lot, applied to a combined $3.6 trillion loan book that adds up to $17.6 billion of lost income each year.

Source: Company accounts

The UK banks are suffering the same grinding margin pressure for the same reasons – tighter regulation, stiff competition plus zero interest rates and QE – with the same deleterious effect on earnings.

Net interest margin   Q2 2018 Q3 Q4 Q1 2019 Q2 Q3 Q4 Q1 2020 Q2 HSBC 1.66% 1.67% 1.66% 1.59% 1.62% 1.56% 1.56% 1.54% 1.33% Standard Chartered 1.59% 1.56% 1.57% 1.66% 1.67% 1.61% 1.54% 1.52% 1.28% NatWest Group 2.01% 1.93% 1.95% 1.89% 1.78% 1.75% 1.77% 1.70% 1.67% Lloyds 2.93% 2.93% 2.92% 2.91% 2.89% 2.88% 2.85% 2.79% 2.40% Barclays UK 3.22% 3.22% 3.20% 3.18% 3.05% 3.10% 3.03% 2.91% 2.69% Source: Company accounts This trend hardly seems likely to break at the moment, especially with the Bank of England publicly pondering negative interest rates and the economic outlook so uncertain. Even so, analysts are still forecasting a big recovery in the FTSE 100 banks’ earnings in 2021, which are seen more than doubling to £22.9 billion at the pre-tax level, relative to 2020’s depressed base. Source: Company accounts, Sharecast, consensus analysts' forecasts That barely exceeds 2010’s total but even then investors do not seem convinced by the forecasts. All of the five FTSE 100 banks shares trade at a discount to net asset, or book, value per share and their combined market capitalisation of £124 billion represents the lowest figure for the quintet since the crisis-ridden days of early 2009. It also represents lower valuation than that afforded to the banks by investors at the turn of the century. Source: Refinitiv data Such a lowly level speaks of huge investor scepticism when it comes to banks’ earnings power in the current environment (although their lowly valuations could present an opportunity should we get an unexpected, inflationary upturn which forces bond yields higher whether central banks like or it not). The US banks are being similarly roughly treated by shareholders as the combined market value of Bank of America, Citigroup, JP Morgan Chase and Wells Fargo stands at just over $700 billion, no higher than it was in 2006. This figure means the five are also valued in total at less than Facebook on its own. Source: Refinitiv data Nor are investors the only people who are sceptical as to the banks’ ability to thrive in the current environment. Regulators seem sceptical, too. The Bank of England has in effect banned dividends and buybacks for calendar 2020 in the UK and the US Federal Reserve has extended its cap on dividend payments and ban on buybacks for large banks for the rest of the year, to ensure that they have enough capital to withstand anything which the pandemic and the economy may send their way. That puts a lid, at least for now, on a bonanza which had seen Bank of America, Citigroup, JP Morgan Chase and Wells Fargo pay out $177 billion in dividend and dish out $343 billion in share buybacks from the start of 2011 to the middle of 2020 – money which would have go a long way to seeing them through their current difficulties. These articles are for information purposes only and are not a personal recommendation or advice.