The health of the American economy and that of its banks are closely related. Sometimes, as in the 2007-09 global financial crisis, dangerous behavior by banks puts the entire economy under pressure. But even if banks are still not causing the country’s economic troubles, their vital signs still tell something about the bigger picture – about people and businesses’ ability to repay debt, willingness to borrow, and appetite for businesses to raise capital in public markets. The banks’ third quarter earnings season, which kicks off Oct. 13, is the next opportunity to take the pulse of banks and assess how the American economy is recovering from the ravages of Covid-19.
The economic turmoil caused by the coronavirus hit banks in both directions. Commercial banking (basically the deposit and credit business) suffered from the economic collapse, but investment banking was booming. When the markets fluctuated at the time of the pandemic, the trading volume of the investment banks rose sharply, as the chance of profit lies in the volatility. In the second quarter, the largest banks’ trading sales hit a record $ 26.9 billion, up 70% year over year.
The heads of the banks have expressed doubts that this premium could last into the third quarter. But the staggering surge in technology stocks and the boom in public stock offerings that fueled them has likely kept the money men preoccupied over the summer. Morgan Stanley and Goldman Sachs, the two big banks that get most of their revenues from investment banking, may not repeat the second quarter breakout, but are expected to see growing sales and steady profits in the third quarter. (Although both of them have done well in investment banking this year, they have been trying to reduce their reliance on it for several years – Goldman by building a retail bank, Morgan Stanley by building wealth management. On October 8, Morgan Stanley said that if it did buy Eaton Vance, an asset manager, for around $ 7 billion in cash and stocks.)
Strong results from investment banks so far have helped offset the damage from the real economy. In the first two quarters of 2020, America’s four largest lenders wrote off the value of their assets by $ 50 billion as they made provisions for anticipated losses on loans. Bank of America, Citigroup, and JPMorgan Chase, which have both large investment banks and huge commercial banks, made profits. At Wells Fargo, which does not, and other smaller banks, these write-downs resulted in losses in the second quarter.
The question now is whether the actual loan losses exceed these provisions or turn out to be less bleak than the banks have prepared. In the past, falling bank profits, which were partly due to provisions in anticipation of poor lending, tended to be followed by the worst credit losses (see chart).
So far there have been no major losses, not even due to official measures to support the economy. Cash was distributed to businesses through the Paycheck Protection Program (PPP). Households were given payments of up to $ 3,400 and unemployment insurance was increased by $ 600 per week. The Federal Reserve kept politics super relaxed (which also stimulated the stock market). Write-downs at the four largest lenders, that is, write-offs on defaulted loans, rose 22% year over year in the second quarter but were still just $ 4.9 billion. The same was true for criminal loans (which were more than 30 days past due) and industry-wide write-offs, which barely increased in the second quarter.
Whether loan defaults will rise more strongly depends on several factors. One is the course of the economy. Most states have started reopening, allowing businesses to generate more revenue than they were in the stricter isolation period in early 2020. If the recovery continues, they are more likely to pay off their debts. If it blocks, it is more likely that they will be used by default.
The other is the prospect of further economic stimulus from the federal government. The impact of the measures that kept consumers and businesses alive over the summer will have subsided in the third quarter. Five out of six PPP borrowers said they had issued their entire loan by the end of August. The additional unemployment benefit expired at the end of July. Democrats and Republicans in Congress have not yet agreed on a second support package. If they ever do, it may prevent some expected losses from occurring.
If the losses turn out to be less than expected, banks that already have $ 2 trillion in equity may be sitting much more – and way more – than they need to meet regulatory requirements. With memories of 2007-09 still unbroken, the Fed wants its shock absorbers to remain well padded. On September 30, the central bank announced that the 33 banks with total assets of more than $ 100 billion would still not be allowed to repurchase shares in the fourth quarter. Unlike banks in Europe, they still pay dividends, but they are capped based on recent earnings.
Additional capital and the return of buybacks would be welcome news for shareholders in the banks that have done well in 2020. Even when the S&P 500 hit an all-time high in the summer, bank stocks remained unloved. The KBW index, which contains a selection of the major listed banks, is worth 30% less than at the beginning of the year.
Banks issue cash – but to the authorities. This week two, the cost of regulatory violations will be reported. On September 29th, JPMorgan Chase agreed to pay nearly $ 1 billion to settle allegations of “spoofing”: market manipulation through fake deals. On October 7th, Citigroup was fined $ 400 million for failing to fix deficiencies in its risk management system. This follows a $ 3 billion fine Wells Fargo paid for settling its counterfeiting scandal in February and a $ 3.9 billion settlement between Goldman Sachs and Malaysia in July for the bank’s role in 1MDB fraud , an investment vehicle. More of it and bank stocks are sure to remain unloved.