As clients know, we have liked and continue to like exposure to banks. We favor the big banks and have a position in the PowerShares KBW Bank Portfolio Fund, KBWB, an ETF that captures the big banks. We also hold KRE and KIE. We are overweight the sector. We will get to why in a minute.
First we want to offer a plug for our longtime friend Chris Whalen. He has a new book out, the result of years of effort. It’s Ford Men: From Inspiration to Enterprise. And he is again writing at theinstitutionalriskanalyst.com. We followed Chris’s work on banks at the IRA for years; it has been very helpful.
Now let’s get to the situation with the banks as we see it.
Earnings
The quarterly earnings parade of the banks is underway. We mostly like what we see. Results being reported are not bad and in some cases are really good.
Among the big banks, only Wells Fargo (NYSE:WFC) is continuing to experience embarrassment over its behavior. Claw-back of the compensation of former leaders is the latest headline. The credit card sales affair and subsequent penalty has haunted WF.
Among the 15 important middle-sized regional banks, only Northern Trust (NASDAQ:NTRS) failed its “living will” test, according to the Fed and the FDIC. Note that Wells Fargo was previously a “living will” casualty and endured some restrictions because of it.
The Upside
Here are some reasons why we think the banks are headed for an extended bull-market recovery cycle.
1. Banking sector returns on assets, returns on equity, and quarterly net income have recovered to about the pre-financial-crisis level. The same is true for loss provisions, while nonperforming real estate loans have been in decline for several years. Net interest margins are in recovery. In sum, the picture of the banking sector is a lot better than it was coming out of the financial crisis.
2. American banks have the ability to fund themselves with low-cost deposits. In a world that wants US dollar funding, American banks have this idiosyncratic advantage over other global banks.
3. The final issue is in the arena of regulatory relief. Here there is debate. Some relief must come through legislation, and this requires accommodation between the Trump administration and the Congress. So far this prospect looks problematic.
4. But other relief can come from what the Wall St. Journal calls the administration’s “power to interpret and enforce financial regulations.” The WSJ analysis notes how this could occur without Congress. Example: Changing the liquidity classification of Fannie Mae and Freddie Mac so that they count just as US Treasury securities do would allow banks to hold more GSE paper. Goldman estimates this change would add 2.5% to annual earnings at the largest banks and 1.8% at the regionals. Separately, this rule change would make it easier for the Fed to reduce the size of its balance sheet by allowing the market to absorb its holdings of GSE paper.
5. Another dramatic change could occur with regulation. Currently, when calculating the coverage ratio, banks have to count their holdings in extremely safe assets like Treasury bills or reserve deposits at the Fed. If regulators were to change the calculation method to exclude these items, the impact would be huge. Keefe, Bruyette, and Woods estimates that this single change could raise earnings at the big eight banks by over 13% next year (2018).
In sum
The banking system has improved and continues to do so. Only a few banks now cause industry embarrassment. Earnings appear to be stabilizing in the post-crisis period. Regulation can give banks a large boost in earnings without Congressional action. If President Trump can obtain Congress’s help, the boost may be even larger.
We like the banks. We own exposure in our separately managed ETF accounts. We disagree with those writers who forecast that “the bank party is over.”