Bank Is not a Four-Letter WordLearn more about this firm
- Since the Great Recession, banks have been a dirty word used by politicians and other pundits. However, banks play an important role in the economy.
- The pace of interest rate normalization will be slow and long, which should lead to an acceleration of credit, which will create a cycle of economic expansion.
- Our investment in commercial banks has been a welcome source of alpha, and we continue to be optimistic on the forward fundamentals for the U.S. economy and U.S. lenders.
One year ago, we laid out the case of why we were increasing our investment in commercial banks. It was predicated on the assumption that valuation was attractive, and mispricing was overlooked by most other investors. Fast forward, this has been a welcome source of alpha for our clients, and we still see more upside given the lever that has not been pulled yet by the banks. This lever is that of revenue growth, which of course requires that the Federal Reserve begin normalizing rates, and in the process, help the economy heal.
Since the Great Recession, banks have been a dirty word used by politicians and other pundits. However, banks play an important role in the economy. Banks are one of the few institutions that can increase the supply of money through increased lending, which thereby assists in economic improvement. The Fed has increased their asset base from $925 million in 2008 to just under $4.5 trillion as of September 2015. This expansion of the monetary supply has been helpful for the economy, but primarily to the market. The help for Main Street comes from commercial banks, which were able to expand their balance sheets from $11.2 trillion in September 2008, to $15.4 trillion in August 2015 (Exhibit 1). While impressive and expansionary, the banks can do much more to help the Main Street economy. The average asset expansion of the banking system in the past three recessions has been 64% this cycle, 31%.
Exhibit 1, Commercial bank asset increases
Banks earn income primarily through spread lending — borrowing from depositors and lending to the public. Lower interest rates were initially a boon for borrowers who benefited from refinancing at lower rates. Seven years later, there is no more stimulative effect for borrowers in maintaining these low rates. For the banking system however, the rate for depositors bottomed out in 2013 and by continuing low rates, loan yields continue to fall even further. The result of stable deposit rates and falling asset yields leads to spread compression and in turn falling revenue for the banks (Exhibit 2).
Exhibit 2, Bank revenue is falling
With falling revenue, banks are still required to pay their real estate bills, hire staff (including an array of compliance officers to meet with post-recession regulations) and operate their businesses to serve their customers. With falling revenue and fairly fixed expenses, banks have no choice but to limit their lending activities to only the most qualified borrowers. This is because their revenue does not possess enough margin to lend to riskier credits that may eventually result in losses (Exhibit 3).
Exhibit 3, Low profit margins force banks to limit lending
It’s time for the Fed to exercise their other dual mandate to help the economy through the oversight of the banking system and their ability to promote the health of the industry by allowing their revenue to expand. As the Fed Funds rate rises, the variable loan portfolio that the main street banks possess will start to incur additional revenue for the banks. This expansion of revenue will allow banks to be able to take on additional risk. Banks should not be risk-averse. Rather, they should take reasonable risks for reasonable rewards. With the Fed Funds rate at 25 basis points (bps), it is difficult to cover losses generated by taking risks. With net charge-offs near all-time lows, this would suggest that the bank portfolios are constraining credit and not providing monetary benefits to their customers. This is not a call to reduce the oversight or allow undisciplined, reckless, risky lending — rather, to encourage the banks to leverage their capital to make incremental loans further on the risk curve that may aid in the growth of the economy.
The reintermediation of banks and credit begins with higher rates to allow for the funding of lending to more risky parts of the economy that spur economic growth. The United States was built on the ability for those with a grand idea to develop and grow a small business. Small- to mid-sized U.S. businesses represent over 48% of jobs, and the Fed, through their oversight responsibilities, should allow banks to expand their lending criteria to help Main Street. This also comes with the responsibility of allowing them to increase their revenue through higher rates. We are not recommending rapid rate increases. Doing so would harm the economy and the banks themselves. Banks work best with modest, gradual adjustments. The Fed made that mistake in 2008 when they cut rates too fast in January in a reaction to the market. Moving the Fed Funds rate 125 bps in either direction is disruptive to the way that banks operate. In 2008, by cutting rates 125 bps in a month, they started to choke banks of spread revenue they would later require to handle the credit crisis, which in turn tightened liquidity across the banking market.
Not all risk is bad. In fact, lending to risky ventures expands the economy. The ability for risk-takers to access capital is essential for a growing economy. While expanding the risk tolerance of our banking economy will lead to modest increase in losses for the banks, doing so with reasonable diversification and prudence will benefit the banks, as they will be able to offer higher loan yield products to justify the increased risk as well as improve access to capital for our economy. This will also help to curtail shadow lending. With the banks out of the lending arena over the past couple of years, more and more volume has been moving to the shadow market. Internet crowdfunding, credit marketplaces and new ventures are now trying to match borrowers with investors. Moving these types of loans back to the banking system is important to maintain the appropriate level of supervision and protection for the borrowers.
We continue to believe that the conditions are ripe to allow for the initiation of a Fed hiking sequence in the near term. Through the forward guidance from the Fed, the pace of normalization will be slow and long, which will be very beneficial to the banking climate and we believe will eventually lead to an acceleration of credit, which will create a cycle of economic expansion. As such, we continue to be optimistic on the forward fundamentals for the U.S. economy and U.S. lenders.