In the latest episode of Industries in Motion, Large Cap Bank Analyst and Head of US Bank Equity Strategy at RBC Capital Markets Gerard Cassidy explains why banks are strong in both earnings and fundamentals as they emerge from the pandemic – and the risks they may face in the coming months.
RBC Industries in Motion EP2 Transcript
Welcome to the Industries in Motion podcast from RBC Capital Markets, where we'll be exploring what's new and what's next in today's fast moving markets and industries, to help you stay ahead of the curve. Please listen to the end of this podcast for important disclaimers.
My name is Mark Odendahl and I am the Head of US Capital Markets research. Let's get into today's episode.
I'm joined today by Gerard Cassidy. Gerard is RBC’s Bank Strategist, as well as covers Large Cap banks. Gerard has been here for nearly three decades. Gerard is also the president and on the board of directors of BAAB. BAAB is the Bank Analysts Association of Boston. And it's also interesting to know that back in the 90s, Gerard was the creator of the Texas ratio, a ratio used by investors to determine whether a bank could be insolvent or not.
Gerard, welcome to the podcast.
Mark. It's a real pleasure to be here. And thank you for inviting me.
So Gerard, over the last 18 months, we've had a bank cycle. How does that compare to the cycles that you've seen over your 30-year career?
Gerard Cassidyor cycles, I went through the: maged, of course, earnings in:
So this one really was quite different than any other downturns we've experienced in my career over the last 30 plus years. And now as we look forward, we think the outlook is actually quite positive for the banks.
You mentioned the industry avoided a credit cycle. Going forward, what do you think the drivers will be for shareholder returns?
Gerard Cassidyy in earnings, kicking off in:
So it's going to come back to the core fundamentals for the banking industry. And the two biggest drivers for fundamental growth to drive shareholder value, over the next 18 to 24 months, will come from loan growth, and a steepening of the yield curve. These factors, obviously, have always been there for the banks, and have always recovered after those cycles that we've been through over the last 30 years. So we expect loan growth to come back. And we also expect to see a benefit or a tailwind from a better interest rate environment that we anticipate over the next 12 to 18 months.
You've talked about a steepening yield curve and the possibility of higher short-term interest rates. You've also discussed this in a recent note that you published about interest rate sensitivity analysis around the top banks in the US. What does the report tell investors about the future profitability of the banks?
Market interest rates are very important to the profitability of the banking industry. It's the cost of their raw material, which is cash. And when you take a look at the current rate environment, the rates are very low, and banks are less profitable in a lower rate environment with a flatter yield curves. Therefore, a steepening curve would add to their profitability.
Now, as you may know, the long end of the curve is affected by a number of different factors. But most importantly, it's being impacted by the Federal Reserve's policy, their monetary policy of quantitative easing. And essentially what that is, is they're coming into the markets every month buying $120 billion of securities, $80 billion of governments and $40 billion of mortgage-backed securities. This is obviously creating excess demand, you could argue artificial demand, and as we all know, when demand exceeds supply, rates come down. We anticipate that, at some point in the future, the Fed will start to taper and what does that mean? That they'll scale back those $120 billion purchases to eventually zero. They've done this once before following the financial crisis. The expectation is that when the tapering ends, or during the tapering period, actually, long term interest rates will start to rise.
Should this take place, that will help benefit the bank's net interest margin, which is equivalent to a gross profit margin for an industrial company. So as the net interest margin rises due to a steepening curve, that will increase the revenue growth for the banks. And so we view this favorably and we anticipate that if the long end of the curve, over the next six to nine months, increases to 1.75% or 2%, you're likely to see a better margin for the industry, which will help their profitability.
Now banks are asset sensitive. And what that means is that the assets on their balance sheet will reprice faster than their funding costs. So in a rising rate environment through a steepening curve, you'll see better revenues coming from the banks as those assets reprice.
So think about it this way – all banks, of course, have securities portfolios. Every month, cashflows come out of that portfolio, those cashflows will be reinvested in higher rates in a steepening curve. Also, loans and other securities purchased will also have higher yields, which will again benefit this net interest margin.
What do you tell investors on helping navigate the banks as interest rates move up? When is it time to further invest in the banks? Or when is it time to take profits?
Gerard Cassidycould raise rates as early as: tightening cycle and the:
So keeping all that in mind, how do you think about loan growth here?
Mark, that’s the number one question investors are asking us about the future of banking. Because the loan growth has not been positive, it's actually been negative. But when you look back at past cycles, this loan issue that we're seeing today is not unusual. And it takes some time for borrowers to start borrowing, again, whether it's corporates or individuals. Now, according to the Federal Reserve data that comes out every Friday afternoon, called the H8 data, the consumer loan growth has already picked up this year. So consumers are back borrowing. You're seeing it, of course, in auto loans, we're starting to finally see some credit card receivable growth, which of course, is very positive. The corporates and the commercial customers have yet to come back. And part of the reason is that there's a lot of liquidity on the corporate balance sheets today.
Now the liquidity is coming down, which is a good sign. There's also uncertainty about the future economic outlook. But the biggest, I think, headwind for commercial loan growth is the very low levels of inventories in this country. We all know about the supply chain issues, everybody sees it when they drive by their local car dealership, and you look at the parking lot, it's half empty. It's not just automobiles, where there's a shortage, it's everywhere. So as the inventories rebuild, we anticipate not only will companies be borrowing for capital expenditures, to build out plant and equipment, but to restock inventory. And if you look at the past two cycles, commercial loans are the last sector of the loan portfolio that does come back. But they do come back.
So we anticipate as the economy grows through the end of ’22, supply chain issues are ironed out and capital expenditures pick up. The banks will benefit not only from the consumer loan growth we're already seeing, but they're going to benefit from commercial loan growth over the next 12 to 18 months.
Keeping in mind what you said about rates, and then what you also said about loan growth, what type of banks are going to do well in this environment?
I think it's going to be a varied benefit, depending on the bank's exposure to the different loan categories. So our so-called universal banks, those are our money center banks, these banks have a very diverse portfolio, they're very big consumer lenders, the credit cards, automobile loans, personal loans, all of this would benefit of course, in a stronger economy. So the universal banks benefit not only from the consumer loan growth, but also for the corporate and commercial loan growth.
Now the universal banks also have to fight the competition of the shadow banking industry, which is essentially the capital markets. So the capital markets are very, very robust. In fact, the debt capital markets had a record year last year in issuing paper. And so I would suggest that the universal banks will benefit, they may not receive as much benefit on the commercial side as the regional banks, but they certainly will benefit in the commercial area, but also the consumer.
You know, on the regional side, this is where the commercial benefit will be the best. Because the regional banks’ customers generally don't have as much access to the capital markets. And these regional banks will benefit as the economy comes back. Particularly, as you know, as the recent Census Bureau indicated, the real growth in this country is in the Southwest and the Eastern parts of this country. And so the banks that have presence there will probably see a bigger benefit from growth than the banks that are in the upper Midwest or in the Northeastern part of the United States.
You just went over several positives for the banks. What are some of the risks to this bullish outlook?
Gerard Cassidyand then more recently in the: g, which happened back in the:
Another risk, of course, not that we see this either, is should an unexpected recession arrive. That would be another issue. And though we didn't have the credit cycle in the last recession, there's always that risk that credit cycle could come back, and could come back stronger, because we avoided one in the last recession.
What are some of the lasting impacts of the pandemic on the bank industry?
Gerard Cassidywith internet banking back in:
And so when we go forward, I think you're going to see an expansion of the digital channel, banks are investing heavily here, they're combating the fintech companies, who have a very narrow focus and are very good, but they just don't offer the breadth of products through the digital channel, which gives the commercial banks the advantage over the fintechs.
So that investment in digital and other investments needed to compete. How is that driving M&A in the banking sector?
Gerard Cassidys. Today, we're down to about: r merger, back in February of:
What other threats can you discuss to the traditional banking model?
I guess the biggest threat to the traditional banking model is the inclination of the biggest technology companies choosing to become bank holding companies. That's not likely. But there's always that possibility. And to obtain a banking charter as a non-bank, you need to create a bank holding company. And so the laws would have to change to allow this to happen. Also, the technology companies would have to see their multiples collapse ahead of time, so that absorbing or becoming a bank would not drag down their multiples. I don't foresee that happening anytime soon.
Now, the other threat is more regulation. Under the new administration, they're much more focused on bank regulation than under the past under the Trump administration. And so that would probably be the more immediate threat is that this administration focuses more on the Consumer Financial Protection Bureau, issuing more regulation to regulate the banks. So that would be the near-term threat. And when I say threat, it's not a threat that would derail the banking system. We're not going to see new regulation, like we saw coming out of the financial crisis, when we had the Dodd Frank bill introduced, which really transformed the industry. But there could be, around the edges, anticipated more regulation from the Consumer Financial Protection Bureau, as they try to level the playing field for customers of banks.
Gerard, thank you very much. This has been a terrific rundown of the banking industry. It shows your decades of experience. Thank you very much for your time today.
My pleasure, Mark, thank you for inviting me.
What else lies ahead in today's ever evolving markets and industries. We'll be keeping track right here on Industries in Motion. Until then, thank you for joining us on today's episode. Make sure you subscribe to Industries in Motion, wherever you listen to your podcasts. If you'd like to continue this conversation or are interested in more information, please contact your RBC representative directly or visit our website, which is www.rbc.com/industriesinmotion for more insights, thank you.