COVID-19 will hurt US bank profitability, but it’s time to buy the banks.

COVID-19 will likely hurt US bank profitability, but we believe the banks are capable of weathering through the current uncertainties. They are in better shape than they were a decade ago and given their current valuations, now is the time to pay some attention to the US banks (NASDAQ:KBWB).

Ferlyn Tan
|
Published on 05 Jun 2020

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• While COVID-19 will likely hurt US bank profitability, we believe the banks are capable of weathering through the current uncertainties.

• The US banks are in better shape than they were a decade ago. They are well-capitalised, and this ensures that the banks have enough cushion to absorb losses and still meet their financial obligations.

• Profitability will be a challenge in 2020, thanks to the rate cuts and heightened volatility in the market, but an expected increase in trading income and debt underwriting fees will help cushion the impact.

• While the economy is likely to remain in a bad shape, investors should pay some attention to the US banks given their current valuations, with an average potential total return of about 13% in the next 1 to 2 years.

• While you can certainly invest in each of the individual banks, those who prefer to have a more diversified exposure to the US banking industry can opt for the Invesco KBW Bank ETF (NASDAQ:KBWB).

2020 has been a volatile year for the US banks so far. In a bid to fight the COVID-19 crisis, the US government launched a massive economic stimulus bill, while the Fed slashed interest rates to near-zero within two weeks. However, the implementation of several measures to slow the fast-spreading COVID-19 virus, including travel bans, social distancing restrictions, and business shutdowns, has still dented the US economy.

As a result, US banks suffered a sell-off as investors anticipate that the economic downturn is likely to set off waves of defaults, while the Fed rate cuts will compress net interest margins (NIM). The oil price war between Russia and Saudi Arabia has further exacerbated the impact of the COVID-19 outbreak, raising the risk of bankruptcies across the energy sector (Chart 1).

Chart 1: US banks recovery lagged behind the broader market

Some of us may recall that during the 2008 global financial crisis, many major banks had to be bailed out by the US government. While there are indeed some similarities between the current COVID-19 crisis and the global financial crisis, such as higher credit costs and NIM compression, we believe the US banks are currently in a much better position than they were in 2008.

The failure of the banking industry back in 2008 was largely due to poor risk management. Since then, however, the US banks have built up stronger balance sheets, become more prudent in their lending business, and their business models have also become more diversified. In other words, they are in a better position to absorb a shock.

In the words of Fed chair Jerome Powell: “After the last financial crisis, the banks more than doubled their capital and liquidity and they’re far more aware and better at managing the risks they’re taking”.

While the COVID-19 fight in the US remains far from over, we believe US banks are capable of weathering through the uncertainties. Once the storm is over, we see strong upside potential in the US banks as they return to their pre-crisis levels.

US banks are in better shape than they were 10 years ago

While the COVID-19 crisis is likely to set off waves of defaults and a surge in provisions for credit losses is imminent, the US banks today are in better shape than they were 10 years ago (Chart 2).

Chart 2: Capital ratios have generally improved over the last decade

While the banks have, on average, more than tripled their provisions for credit losses in their 1Q20 earnings results, resulting in a decline in their respective CET1 ratios, the big banks remain well-capitalised, with their capital ratios continuing to meet the Fed’s stricter requirements (Table 1).

Table 1: US banks on more solid footing compared to 10 years ago

	CET1 ratio (minimum: 4.5%*)	Total capital adequacy (minimum: 8.0%*)	CET1 ratio (Fed's requirement^)	Total capital adequacy (Fed's requirement^)
JP Morgan	11.5%	16.0%	10.5%	14.0%
Citi	11.2%	16.0%	10.0%	13.5%
Bank of America	10.8%	14.8%	9.5%	13.0%
Wells Fargo	10.7%	15.3%	9.0%	12.5%
_{Source: Company annual and quarterly reports, iFAST compilations} _{*Minimum requirement is based on Basel III} _{^Fed’s requirement includes a minimum CET1 requirement, a capital conservation buffer, and a G-SIB surcharge} _{Note: Total capital adequacy ratio is based on 2019 annual report} _{Data as of June 2020}

Having adequate capital is important because it ensures that the banks have enough cushion to absorb losses and still meet their financial obligations. In the event that a bank does not have sufficient capital in times of crisis, it will eventually lead to either insolvency or share dilution, as in the case of Lehman Brothers and Citigroup back in 2008. As such, it is understandable that many investors are worried that history may repeat itself.

However, we would like to highlight that the US banking industry has evolved tremendously over the years. Many strict regulations were enforced on the large US banks to make sure that they are not taking on unnecessary risks with their deposits, and as shown in Table 1, the larger US banks today are well-capitalised to meet their financial obligations.

Therefore, the possibility of insolvency or massive share dilution is low as the US banks are on more solid footing with stronger capital positions, allowing them to deal with the turbulence in the current market.

Profitability will likely get hit by COVID-19 in short-term but there are silver linings

While the US banks are well-capitalised to weather through the current uncertainties, their profitability will likely be affected in 2020 due to lower income generated and higher loan loss provisions. The current near-zero interest rate levels will reduce the banks’ net interest income and we also expect to see downward pressure on fee revenue earned from their asset management and investment banking businesses due to heightened volatility in the market. The drastic increase in loan loss provisions will also take a bite out of the banks’ profits.

As interest rates are at an all-time low, more companies may also take advantage of this current situation to issue new debt. A total of USD1.01 trillion of debt was issued in US debt capital market in 1Q20, and this is the second-highest volume since 2007. As you can see in Table 2, the top ten investment banks have underwritten more than half of what they have accomplished in FY2019 in just five months into 2020. Hence, we believe the current interest-rate environment bodes well for banks with capital markets arm involved in the fixed income underwriting business.

Table 2: Global debt capital market (DCM) deal value

Bookrunner	Value of DCM deals YTD 2020 (USD bn)	Value of DCM deals FY2019 (USD bn)
JPMorgan	310.8	481.9	64.5%
Citi	256.8	433.7	59.2%
BofA Securities	256.4	376	68.2%
Goldman Sachs	173.3	309.8	55.9%
Barclays	168.7	299.1	56.4%
Morgan Stanley	161.3	259	62.3%
HSBC	137.1	241.4	56.8%
Deutsche Bank	134.4	228.3	58.9%
BNP Paribas	133.8	220	60.8%
Wells Fargo Securities	133.7	218	61.3%
Subtotal	1,866.1	3,067.0	60.8%
Total	3,734.8	7,243.3	51.6%
_{Source: Dealogic, Wall Street Journal, iFAST compilations} _{Data as of June 2020}

Besides, market volatility may also help to drive transaction volumes in the banks’ securities business, which can help to offset some losses in the banks’ non-interest income. The trading desks of the banks have also thrived during this market correction as volatility elevated trading volumes across all products.

On the other hand, although there has also been a surge in lending, loan provision remains to be a big concern for the big banks. Many of them are still expecting higher loan loss provisions and will continue to build their reserves in the second quarter. While this is largely due to the deterioration in customer credit quality, another reason behind the increasing provisions is the adoption of the new credit loss accounting standard – Current Expected Credit Losses (CECL) – at the start of this year.

Under the new CECL model, loss estimation is more forward-looking, and is done based on not just past incurred losses, but also future expected losses due to the state of the economy. This requires the banks to set aside additional capital based on future macroeconomic conditions, which explains the jump in provisions as compared to prior years.

While this new accounting standard is likely to lead to an increase in loan provisions in the short-term, the good thing is that investors will not be “caught by surprise” by rising defaults in the next few quarters, as a portion of it would have already been reflected in the reserves set aside for loan losses.

Dividend payments by the US banks are sustainable

Several big US banks have suspended their share buyback programmes to maintain ample capital and liquidity amid the COVID-19 pandemic. However, the US banks continue to have decent dividend yields of about 2.1% (after dividend withholding tax).

That being said, many investors are worried about the sustainability of the banks’ dividends due to the increased reserves which may lead to less capital available for dividends. First, we are not ruling out the possibility of a dividend cut especially if the economy continues to worsen, but if we look at the banks’ 2019 dividends, paying common dividends will only affect the banks’ equity capital base by about 40-70bps. Therefore, the US banks still have adequate capital to maintain their dividends at this juncture. On top of that, various management teams have also guided that they will stay committed to paying their dividend which should further support the sustainability of the US banks’ dividend payments.

Badly beaten US banks may signal a buying opportunity

The share prices of US banks have been badly beaten over the last two months. While the economy is likely to remain in a bad shape, the US banks are currently trading at attractive valuations (Chart 3).

Chart 3: Valuations of US banks have fallen drastically

Relative to their last traded price, the top three US commercial banks have an average potential total return of about 13% in the next 1 to 2 years. Our valuation methodology is built on a fair PB ratio derived from the Gordon Growth Model (Table 3).

Table 3: Top 3 commercial banks in the US offering decent upside potential

	PB ratio	Target price (USD)	Current price (USD)	Upside potential	Dividend yield
JPMorgan (NYSE:JPM)	1.6	119.1	106.4	11.9%	3.2%
Citibank (NYSE:C)	0.8	61.7	55.6	11.0%	3.5%
Bank of America (NYSE:BAC)	1.1	28.8	26.7	7.9%	2.5%
Average:				10.3%	3.0%
_{Source: Bloomberg Finance L.P., iFAST estimations} _{Data as of June 2020}

Unlike its international peers, the business models of these larger US banks are also more diversified. They generally derive about 40% – 50% of their total net revenue from non-interest income, while its international peers, like Singapore and Chinese banks, derive approximately 15% – 30% from non-interest income. Hence, this could suggest a level of support for the US banks’ net revenue as the current situation bodes well for trading and fixed income underwriting fees, which represent roughly 20% of the US banks’ total net revenue.

While the US banks face short-term headwinds, investors who take a longer-term view and can stomach wild swings in the market can consider investing in US banks through the Invesco KBW Bank ETF (NASDAQ:KBWB), which tracks the performance of 24 leading banks and thrifts that are publicly-traded in the US.

The ETF consists of three types of banks – banks with both investment and commercial banking operations, custodian banks and pure-play commercial banks. Banks that derive their revenues largely from investment banking or insurance are omitted from this index (Table 4).

Table 4: Top ten holdings of Invesco KBW Bank ETF

Name	Weight	Type of bank
Bank of America Corp	8.5%	Investment and commercial bank
JPMorgan Chase & Co	8.1%	Investment and commercial bank
Citigroup Inc	7.7%	Investment and commercial bank
US Bancorp	7.5%	Pure-play commercial bank
Wells Fargo & Co	6.4%	Investment and commercial bank
First Republic Bank/CA	5.2%	Pure-play commercial bank
Bank of New York Mellon Corp/The	4.5%	Custodian banks
State Street Corp	4.4%	Custodian banks
Northern Trust Corp	4.4%	Custodian banks
PNC Financial Services Group Inc/The	4.3%	Pure-play commercial bank
_{Source: Bloomberg Finance L.P., iFAST compilation} _{Data as of June 2020}

Therefore, investors who prefer a diversified option should consider the Invesco KBW Bank ETF (NASDAQ:KBWB), which is our preferred choice to gain exposure to the US commercial banks based on our selection methodology. With an expense ratio of 0.35%, we believe this ETF is also able to help investors get exposure to this industry without eating away their returns.

Chart 4: KBW Nasdaq Bank Index vs. its book value

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

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COVID-19 will hurt US bank profitability, but it’s time to buy the banks.

Ferlyn Tan

Published on 05 Jun 2020

Chart 1: US banks recovery lagged behind the broader market

US banks are in better shape than they were 10 years ago

Chart 2: Capital ratios have generally improved over the last decade

Table 1: US banks on more solid footing compared to 10 years ago

Profitability will likely get hit by COVID-19 in short-term but there are silver linings

Table 2: Global debt capital market (DCM) deal value

Dividend payments by the US banks are sustainable

Badly beaten US banks may signal a buying opportunity

Chart 3: Valuations of US banks have fallen drastically

Table 3: Top 3 commercial banks in the US offering decent upside potential

Table 4: Top ten holdings of Invesco KBW Bank ETF

Chart 4: KBW Nasdaq Bank Index vs. its book value

Ways to Invest with FSM Global

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COVID-19 will hurt US bank profitability, but it’s time to buy the banks.

Ferlyn Tan

Published on 05 Jun 2020

Chart 1: US banks recovery lagged behind the broader market

US banks are in better shape than they were 10 years ago

Chart 2: Capital ratios have generally improved over the last decade

Table 1: US banks on more solid footing compared to 10 years ago

Profitability will likely get hit by COVID-19 in short-term but there are silver linings

Table 2: Global debt capital market (DCM) deal value

Dividend payments by the US banks are sustainable

Badly beaten US banks may signal a buying opportunity

Chart 3: Valuations of US banks have fallen drastically

Table 3: Top 3 commercial banks in the US offering decent upside potential

Table 4: Top ten holdings of Invesco KBW Bank ETF

Chart 4: KBW Nasdaq Bank Index vs. its book value

Ways to Invest with FSM Global

Don't have an account with us?

Need Financial Advice?

Latest Articles More

Live Chat 8:30am to 10:30pm, (Mondays to Fridays excluding PH) and 8:30am to 12:30pm, (Saturdays excluding PH)

Select Country/Region

Live Chat
8:30am to 10:30pm, (Mondays to Fridays excluding PH) and
8:30am to 12:30pm, (Saturdays excluding PH)