Why Lower Interest Rates Aren’t Hurting Bank Stocks

Art by Marc Rosenthal

The financial crisis was a reputation-destroyer for banks, whose reckless lending played a big role in causing the catastrophe. Back in 2008, their shares plunged into the market’s sub-basement. Well, that was then. Today, bank stocks are back near their pre-recession high.

What’s odd is that this comeback is happening amid dropping interest rates, which usually lead to bank profits getting crimped. Changes in the banking industry, however, have convinced investors lately that the lenders can both withstand the next recession and turn out decent returns in the meantime. Banks are more solid structurally these days than they were pre-crisis. Plus, their investments in technology bode well for their future.

Banks will never be hot stocks. Their returns on equity, a measure of growth potential, are mostly in the low teens, versus 56 for tech darling Apple. Nonetheless, banks are the blood circulatory system of the economy, so the need for them has never gone away. And 2008 is a dozen years ago. “They were vilified for starting the crisis, but that has faded,” said Rutger Van Faassen, vice president for consumer lending at Informa Financial Intelligence.”

The recovery of banks’ stocks has been gradual and started from a low base. The KBW Nasdaq Bank Index fell 86% from its June 2007 high to its 2009 low. During that horrific period, the S&P 500 suffered, too, albeit not that badly. The broad market index slid by 51%. Amid a belatedly booming economy, bank shares took years to struggle back. In 2017 and early 2018, they put on a spurt, almost reaching the 2007 high, courtesy of looser regulation, tax cuts, and rising interest rates. Then, amid talk of an onrushing recession, they sank anew last spring. A recession would bring a surge in defaults, harming banks stuck with these non-paying loans. 

An economic downturn failed to appear, though, and now few expect a recession anytime soon as unemployment remains low and consumer confidence flies high. “Investors breathed a sigh of relief,” noted Bryce Doty, senior portfolio manager at Sit Investments. Result: Starting last October, the KBW benchmark began climbing once more, gaining 19% and is now within a microscopic distance from the ’07 peak.

Adding to banks’ allure, Warren Buffett has invested in bank stocks over the past year. Yes, the Oracle of Omaha is human and therefore fallible (the 2005 Kraft-Heinz merger he engineered has lost almost two-thirds of its value since), yet his track record is pretty darn good. His Berkshire Hathaway holding company is now one of the biggest US bank shareholders, with stakes in behemoths like JPMorgan Chase (JPM) and Bank of America (BofA).

He told CNBC that financial companies are “very good investments at sensible prices.’’ Banks have price/earnings ratios in the low teens, compared to 25.6 for the overall stock market. He deemed them “good businesses.” Buffett also appreciates stock holdings that pay sweet dividends, which is the case with banks. JPM has a dividend yield of 2.6%, almost a full percentage point above that of the S&P 500.

What Low Interest Rates?

Ordinarily, the Federal Reserve’s policy reversal last fall should’ve been bad news for banks. The Fed pivoted from its campaign to hike short-term rates and started lowering them, in three quarter-point steps, saying it would reduce them further if need be. Banking companies make their money from lending. They depend upon charging borrowers more than the interest they pay depositors. Thus, when the gap shrinks between the two, as measured by what’s called the net interest margin, lenders’ profitability picture darkens.

Banks have barely reduced the rate they pay depositors, while the amount they charge borrowers has dropped almost a full percentage point in the past year. The one-year certificate of deposit’s rate now averages 0.82%, not too far off from the 0.89% from 12 months ago, down just 0.07 points, according to Bankrate. Why don’t banks pay depositors less, with the Fed pushing down its benchmark rate? Because such a move would drive these customers away. At the same time, Freddie Mac reports that the 30-year mortgage’s average rate has fallen faster, to 3.7% from 4.5%, or 0.8 points. Margins nudged down in the third quarter and expectations are for a dramatically worsened number for the fourth period.

Offsetting the compressed margins is that deposit volume has increased as of 2019’s third quarter, by 5.8% year over year. This means that there is a larger base of deposits, giving banks a bigger cushion. Certainly, bank interest has been low for years, in response to muted inflation. That has driven a lot of money into the stock market, where superior returns are rife. But a  lot of people recall the 2008 fright show and still entrust a chunk of their money to the safety of a bank, whose deposits are protected by the FDIC. So, they put up with low rates.

Banks can afford lower margins on the spread between deposit and loan interest. Consumer lending has been robust, which also helps them to outweigh the problem of lower margins. Example: JPM’s 2019 third quarter last year, when the bank cited solid growth in credit cards, mortgages, and auto loans.  “The consumer remains healthy with growth in wages and spending, combined with strong balance sheets and low unemployment levels,” CEO Jamie Dimon said in the release.

His net interest margin slid in the third quarter to 2.41%, which is 0.12 percentage points below the year-prior period. Note that this didn’t stop JPM from increasing its earnings by 8%.

Profits Are Perking

While banks have fared well overall in the market, the best performers are the biggest institutions, due to their scope. The top banks by assets—JPM (No. 1, with $2.74 trillion in assets), BofA (No. 2, $2.38 trillion), and Citigroup (No. 3, $1.96 trillion)—saw their shares gaining 42%, 43%, and 53%, respectively, in 2019. Those returns exceeded the S&P 500’s 29% increase, not to mention the 32% for the bank index.

Banks big profit jump started in late 2017. That’s when quarterly income exceeded $50 billion. While earnings in 2019’s third quarter dipped slightly from the year-prior period, the Federal Deposit Insurance Corp. (FDIC) attributed that to nonrecurring events at three institutions, such as their diverting money to increase their loan loss reserves. Loan growth remained robust and the number of problem banks, which are in danger of being shuttered, stayed low.

The profit situation is encouraging for companies across the industry, from small to large. Earnings for JP Morgan’s third quarter last year rose that 8%, to $9.1 billion, or $2.68 a share, blowing past the $2.45 estimate of analysts surveyed by research firm Refinitiv. JPM revenue also increased 8% to a record $30.1 billion, exceeding the $28.5 billion analysts’ estimate. Bank of America, which almost capsized during the crisis owing to its staggering amount of rotten sub-prime mortgages, has racked up similar good results. Smaller banks’ net income jumped 7.2%, the FDIC reported.

Sturdier Structures

The core story of the financial crisis is that banks were too gung-ho on excessive, badly understood risks, and had too little cash on hand to cover losses. Although bank executives are loath to admit it publicly, new federal rules after the crisis have done much to put their companies in a stronger position. The Dodd-Frank law, passed in 2010, reined in banks’ abilities to speculate, and gave enhanced powers to the Fed and other agencies to serve as watchdogs over the banking system.

A big requirement was to boost the amount of liquid capital (assets easily sold) that banks must maintain, as a buffer against bad times. Under the Volcker Rule, named after the late Fed chief Paul Volcker, banks are restricted from trading for their own accounts. Now banks must undergo “stress tests” to ensure they could handle an economic slump and its attendant explosion of loan defaults.

In 2016, Donald Trump said he would overturn Dodd-Frank, once he became president. That effort failed, but Congress did ease some of the regulatory burden on banks, especially the small lenders, and simplified the Volcker Rule. Regardless, no one doubts that banks are better suited for survival than before, which is a comfort to bank investors and to society at large.

Tech Transformation

In the post-crisis era, many non-banks have emerged or expanded, bent on providing services that traditional institutions have long furnished. PayPal, founded in 1998, pioneered online payments without using the banking system. Square, which started out as a PayPal imitator, now offers what amounts to a bank account, complete with debit cards.

Tech-based upstarts called neobanks, like Chime and Moven, aren’t encumbered by branches and offer some basic banking services at a cut rate, notably fee-free online checking. With an infusion of venture capital investments, they pledge to do away with annoyances like overdraft penalties and seldom make you wait to execute a money transfer. But the neobanks generally offer just a narrow range of services, on the order of checking.

Behind their tech razzle-dazzle is the cold fact that many of these tech tyros are partnered with established banks, which have much more solid platforms. Gaining a banking charter from Washington—which would bring FDIC insurance—is difficult. Neobank Social Financial, for instance, has an alliance with WSFS, formerly Wilmington Savings Fund Society, founded in 1832. That gives SoFi, as it’s known, the benefit of deposit insurance. Alphabet’s Google is in talks with Citi about getting into the banking game.

Banks, particularly the international giants like JPM and regionals such as SunTrust in the nation’s southeast, are getting into the tech world and copying some of the neobanks’ tactics. They’ve adopted mobile apps and explored fee waivers. While many banks are closing branches, they simultaneously are opening new outlets in more promising areas. As JPM’s Dimon has said, despite the apps’ popularity, people “hardly ever open a bank account until we open a branch nearby.”

The full range of services that established banks have is tough to beat, said Randy Rosen, Informa’s vice-president for benchmarking and applied analytics for deposits. Banks, he continued, have “stickiness,” meaning that it is difficult to leave them. To do so involves unwinding a tangle of checking, debit, bill-paying, and maybe wealth management advisory arrangements. “Moving is tough for customers,” he maintained.

Thanks to deposit insurance, Rosen added, “they want to go to where they feel safe.” With banks doing well again, that’s a powerful incentive. Plus, it’s a boon for bank stockholders.

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