Should We Worry About the Banks & Their Role in this Financial Crisis?

Michael Kon, CFA

Should We Worry About the Banks & Their Role in this Financial Crisis? image

Among other industry groups, the commercial bank stocks have taken a hit in this bear market. We thought we would respond to the key questions we have fielded from clients about the banks and explain why we have confidence in them.

What are the principal concerns that have been expressed about the banks?

  • The memories of the global financial crisis are still fresh in investors’ minds. Market participants are concerned about the stability of the financial system and are worried that we are headed towards a repeat of 2008.
  • A significant portion of bank revenue comes from spread income, which is the difference between interest charged on loans and the interest paid on deposits and other borrowings. The rates that banks charge depend on general market rates, which are being influenced by the Federal Reserve Bank. Market participants are concerned that the recent rate cuts by the Federal Reserve will pressure bank revenue.
  • Investors are worried that the shutdown of large parts of the global economy is likely to be followed by a severe recession that will result in a sharp increase in loan losses.

What’s the probability that this crisis affects banks as they did in the global financial crisis in 2008?

We don’t think it’s high. Here is why:

  • Loan underwriting standards are substantially higher than in 2008.
    • Lax lending practices stand out to us among the causes of the 2008 financial crisis. This isn’t the case today. Banks have become significantly more disciplined in their underwriting of loans and most loan books are well prepared to withstand severe economic shocks.
  • More stringent regulation and capital requirements have led to stronger bank balance sheets.
    • New rules and regulations that were put in place after the global financial crisis of 2008 significantly limited the banks’ ability to take on the types of risks that were common on banks books before 2008.
    • Each year, the largest banks go through a rigorous stress test that examines how well they are prepared for a sharp economic downturn. All of the largest banks passed last year’s stress test.
  • Bank liquidity is vastly improved.
    • In 2008, the global financial system was the epicenter of the crisis. Market participants lost their confidence in the banking system and depositors pulled out their deposits from multiple banks that were at risk. The banking system was starving for cash.
    • Today, we believe the banking system is sound and healthy and flushed with cash, while industries such as aerospace, travel, retail, and hospitality might soon be starving for cash. If our thesis is correct, this means the demand for bank loans is set to rise, which isn’t necessarily a bad thing for the banking system. In fact, many companies that we follow have already tapped their credit lines to prepare themselves for the upcoming revenue shortfall caused by the response to the coronavirus. The liquidity crunch is happening in the economy and banks are stepping in to meet the demand, which is exactly what they are supposed to do. We think loan growth in the coming quarter could even offset some of the spread pressures banks will experience from lower rates.
    • We believe the main issue is that banks might not have enough capacity to meet the demand for loans. This is a good problem for sound and careful lenders to have, but from the economy’s perspective, this could be an issue. If lending capacity is constrained, some businesses might not have enough cash to survive. Regulators are aware of the issue, and consequently the Federal Reserve has added extra liquidity to the system so that banks will have enough capacity to meet the coming demand for loans.
  • The regulatory response to this crisis has been rapid and dramatic.
    • Regulators and the government were slow to react to the 2008 crisis. Even after Lehman Brothers collapsed, many regulators and policy makers didn’t grasp the severity of the situation.
    • While the efficacy of the government’s response to the current medical crisis can be debatable, the response to the deteriorating economic conditions has been swift. The Federal Reserve has dramatically cut rates and immediately restarted quantitative easing while encouraging banks to drop their buybacks and tap its liquidity facilities so that lending will continue uninterrupted. Based on the news coming from Washington, we believe more programs might follow, which means that the banking system will have sufficient capacity to meet demand. Banks are open for business.

 

Won’t loan losses go up during the coming recession?

Absolutely. We think loan losses are headed higher.  But we think our banks are prepared:

  • Loan losses are at record lows and banks are well reserved, and it’s our opinion that this system is well prepared to absorb much higher loan losses. This was not the case in the 2008 financial crisis.
  • Credit cycles are part of the banking system. There are periods that loan losses rise and there are periods that they decline. Banks prepare for these cycles by holding reserves and capital to mitigate the impact of loan losses on their financial position. The intrinsic value of any bank is a function of its earnings power through the entire credit cycle, and not just the period when loan losses go one way or another. A change in the direction of loan losses shouldn’t change the underlying value of the business. This is just an integral part of the business model.

With so much uncertainty out there, why should we own bank stocks?

  • In part because of the confidence we have in their financial strength, as described above, but also because the stocks are incredibly cheap. All of the banks in our portfolio now trade below book value, which means the stock is lower than the value of the assets net of liabilities. We think this is an incredibly low valuation for any bank, but especially for the high-quality franchises that we own in client portfolios.

We will keep a close eye on our bank holdings, as with everything else in our portfolios, and will take action where warranted. Learn more about our investment strategies and reach out to be connected with one of our financial advisors.

 

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