In the early days of the Covid-19 pandemic, bank bulls argued that, if the lenders were to weather the storm, their shares could come out the other side with higher valuations.
Despite a strong recovery in their profits since the 2008-09 financial crisis, and balance sheets that have been rebuilt under the beady eyes of regulators, banks have not lost their reputation as fundamentally unreliable investments. But, said the bulls, if banks could make it through a short, sharp recession without reporting losses and without needing to raise capital, they would finally re-rate, and their price/earnings ratios would no longer languish at levels well below the wider market.
The argument was appealing then: the biggest banks, in particular, are not only much better capitalised now but also enjoy great advantages of scale, particularly in digital banking. They should be able to generate steady profits through a cycle.
So, how is the argument holding up, four months later?
We can say with certainty that investors are not yet convinced that banks have become safer. Shares in the US banking sector are down about a third since February, and the sector has mostly sat out the rebound rally enjoyed by the market.
But the biggest problem for the group has not been that assets have turned sour: it is that their lending margins have been squeezed by falling interest rates and a flat yield curve. The consensus expectation is that, between Federal Reserve activism and limp global growth, rates will be low and the curve flat for a very long time to come.
Rates have not been the only challenge, though. The very parts of big banks’ businesses that were expected to provide stability in tough moments — their huge consumer banking franchises — have not held up well in the crisis, as second-quarter earnings reports this week have shown.
Consider the vast provisions for bad loans announced this week — $10.5bn at JPMorgan Chase, $9.5bn at Wells Fargo and so on. These are big numbers, but all they tell you is that accounting rules force banks to guess what the future holds, at a time when the outlook is blanketed in a pea-soup fog.
For all their expertise in pricing risk, the banks do not have a better idea of the probable trajectory of the economy than any diligent reader of this newspaper. The provisions are artefacts, and we will not find out whether they correspond to reality for months. In the meantime, though, it is obviously tough going on Main Street.
At JPMorgan, pre-provision profits in the consumer banking division were down 16 per cent in the second quarter. Much of the pain came from a 20 per cent drop in income from credit cards. Spending volumes, loan balances and interest rates are falling. The pattern was similar at Citigroup, where card revenues were off 9 per cent.
This makes two things clear. One: US consumers are rightly scared of card debt. Even when they still have jobs, or enjoy significant government income support, they put the plastic away. Second: cards are the cornerstone of profits at the big banks’ consumer franchises.
Those ubiquitous branch networks and whizzy mobile apps are a distraction, in that context. Deposit collection is important but cards are where the money is, and cards are an intrinsically volatile business.
The bulls might reply by pointing to the fat profits the big banks made from capital-markets activities during the second quarter. The same conditions that spooked cardholders were a bonanza for trading desks.
This is true as far as it goes. But investors do not much care about trading profits, for the simple reason that they come and go. This week, when Goldman Sachs reported a 150 per cent increase in profits from trading fixed-income — contributing to earnings per share that were almost double analysts’ expectations — its shares rose by all of 1 per cent. Morgan Stanley’s markets results were even more impressive; its shares were up by about 2 per cent in early trading on Thursday.
All is not lost. If, when the crisis has finally receded and the credit losses are counted, banks have not been forced to raise capital, they may have a case that the industry has truly transformed since 2008. And if, when that sunny day arrives, interest rates are on an upward trajectory, banks will enjoy a rally.
But the thesis that better-capitalised banks can make anything resembling steady profits through a recession already looks weak.
We are learning, once again, that no matter how solid and conservatively run the banks are, their net income is subject to big swings. So the dream of higher valuations remains just that.