You Can Bank on It

We are now over a year into the pandemic. Are banks well positioned? In episode 8, we compare The Great Lockdown versus The Great Financial Crisis of 2008 from a banking perspective.

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Jeffrey Addis:

Welcome to our podcast. My name is Jeffrey Addis. I am the President and Chief Operating Officer of Merganser Capital Management. Before we begin, a few important regulatory disclosures. This presentation is for informational purposes only and should not be considered as investment advice or a recommendation of any particular issuer, security, strategy or investment product. Now, on to our podcast.

Mike Cloutier:

Welcome to a bird's eye view of the Bond Market Podcast. My name is Mike Cloutier and I'm the Chief Marketing Officer from Merganser Capital Management. I'm joined today by my investment team colleague, Mu Tang. Mu is a corporate credit research analyst covering financial institutions and the consumer sector. I thought it would be an interesting moment in time to check in with you, Mu, based on the rate environment that we're currently living in as well as the recent change and the introduction of the Biden Administration in Washington. To start, would you mind talking a little bit about the economic consequences of the pandemic thus far for banking specifically, and maybe compare that to the great financial crisis? And then, within your answer, maybe chat about loan loss expectations and how banks are provisioning capital right now to buffer any negative impacts.

Mu Tang:

Yeah, sure, that's a good question to start, I think. Frankly, the credit consequences for banks have been a little bit more muted, given the wide array of stimulus and liquidity initially injected into the system. For example, we saw PPP, Main Street lending at various institutional liquidity facilities come online in 2020. I think the big difference this time around versus the financial crisis is that banks are starting off from a position of strength. When you look at the crisis itself, a large majority of the roughly 300 banks or so that failed in the '08 to 2010 period failed because of poor underwriting and inadequate reserving. Flip to today, and the domestic banks within our coverage universe have more than reserved their share of expected losses within their loan book.

Just to throw out some numbers, the median reserve to expected credit losses in a severely adverse stress test scenario jumped to around 60% as the pandemic reared its head so that's a pretty eye-popping number. Assuming we make meaningful progress in containing the virus, we may see reserve releases later this year which should be a tailwind to profitability. But again, that outcome is really contingent on exogenous factors like vaccine distribution, the impact of a second, third wave and various virus variants and, most importantly, ongoing fiscal and monetary support.

Mike Cloutier:

Interesting. So when you talk about reserve releases, so this is regulators basically giving them the all clear or the green light to release that capital and then the banks will then in turn decide whether that's best deployed as a share repurchase or however they choose to kind of roll it up, is that the right way to think about it?

Mu Tang:

I would say that the reserve release and as well as the dividend and share buybacks are, in some ways, two distinct things. I think from that lens, yeah, you might see some reserve releases flow through into dividends but I don't really think the two go hand-in-hand, per se.

Mike Cloutier:

So net net, based on everything you just said, it sounds like we're starting from a position of greater strength today amongst the major financial institutions. Therefore, losses are forecast relative to what they were, it's kind of apples and oranges just based on the starting point a little bit?

Mu Tang:

Yeah. I think the comparison between the financial crisis and where we are today is that we're facing a pretty large unknown from a credit underwriting perspective, but I think one of the biggest differences that makes it different today is that, we might touch upon this later, is that banks were very ahead of the curve in terms of tightening credit standards as macro conditions changed from the pandemic.

Mike Cloutier:

Okay. Maybe next, can you talk a little bit about how different bank revenue sources have done and what is the role, in your view, of the bank branch, and has digitization accelerated that in any other areas of the economy? Just seems like more and more is trending to non-personal interactions these days, so just curious.

Mu Tang:

I'd say, broadly speaking, we've seen pre-pandemic growth across CNI, CRE, and consumer lending but, as I've talked to in the previous question, I think one of the biggest differences is that banks were very quick to tighten their lending standards as conditions deteriorated. I think, going forward, one of the more interesting things to monitor is how CRE loans develop because we're facing some interesting challenges, given this secular shift in office space demand in this post-COVID world. As it relates to bank branches, historically, branch footprint rationalization or branch closures. They really helped improve the underlying profitability and I think this pandemic accelerated that trend even more, given the need for social distancing. As banks shift away from this physical footprint, we've seen more focus on digitization and a lot of larger banks have invested billions of dollars in this technology to compete in this new digital banking landscape. I think some of the work is cut out for the smaller regional side because there's a lot more work to be done on the technology front for them.

Mike Cloutier:

How about M&A activity right now, especially against the backdrop of just cheap debt financing?

Mu Tang:

Yeah, so technology spend is going to be a huge factor for some of the smaller to mid-sized regional banks and I think the pickup in M&A activity in the last few years, whether you look at BB&T SunTrust, PNC, BBVA or Huntington and First Merit, those transactions have really paved the way for management teams to look at M&A as an opportunity to increase scale while also taking out structural costs. I think, on that front, we're going to see more focus on getting scale, growing that footprint, and improving funding mix, all while keeping it within their credit underwriting expertise. Also, the other thing that we're monitoring is basically the re-entrenchment of certain Yankee banks back into their core European and Asian geographies because we think this presents an opportunity for some of the domestic banks and even Canadian banks to increase that scale through the acquisition of these legacy US operations.

Mike Cloutier:

Interesting. What would be one example of one of these Yankee banks that you could see that happening?

Mu Tang:

Yeah, I think HSBC has telegraphed in the past that they're looking to exit from their US business. Same thing with BBVA, so we're going to probably see a continuation of that in the future.

Mike Cloutier:

Got it. Definitely no surprise that under the Trump Administration we saw a pretty meaningful relaxation of certain crisis error regulations related to things like the broker rule, bank capital requirements, and then certain things on the consumer protection side. I know there was definitely some legislation around payday lending and things and, under Biden, I think there's expected to be quite a large shift in direction. How do you expect these things to change and how tough do you think the new administration may be on Wall Street and the banking sector more broadly?

Mu Tang:

Yeah, I mean, that's a really good question. I think, at the heart of it, one of the most important things to keep in mind is that while the Trump Administration relaxed certain crisis error regulations, we haven't seen a wholesale rollback of these rules. Some of the regulatory landmarks of the great financial crisis still remain intact. I'm talking about liquidity ratios, BASL three, bill and debt implementation. I think today's banking industry is very mature, from a regulatory perspective, and a lot of the work on the regulation front is probably going to be relegated to public enemies of today, like big tech and private equity. From this perspective, I think any changes from this new administration will be more incremental than a fundamental shift.

Mike Cloutier:

Got it. At this point in the cycle, we still sit at incredibly accommodative levels of interest rates. The Fed has signaled certainly that things are likely to stay that way and they're going to be supportive and patient. I guess the big question is, can banks make money in this environment and are they attractive from a debt perspective? I mean, we hear steeper yield curve is typically good for financial institutions in the way of net interest margin. Obviously, some banks have done a better job of expanding into wealth management and these additional revenue lines and businesses. Just curious, amongst this rate backdrop and everything else, is this a good time to be in banking?

Mu Tang:

Yeah, that's been a concern about this space in the last couple years. Certainly low rates and flat curves are going to be challenges to bank profitability, but we've seen some curve steepening in the last couple weeks so that's allayed some of our concerns there. The other thing to keep in mind, and you've pointed this out, is that a lot of the banks in our coverage universe have diversified away from traditional spread lending and into more what you would consider fee income oriented businesses. These are generally less rate sensitive and these fee businesses include wealth management, treasury, and mortgage servicing, to name a few. This line of business is a pretty decent offset in a low to flat rate environment because it's just not as rate sensitive. On the cost side, I think banks can take out some of the structural costs to improve profitability and we've touched upon branch closures as one aspect of that. While the current rate environment will be challenging, I think there's going to be still enough levers to pull for the sector to kind of weather the storm at this point.

Mike Cloutier:

Interesting. Well, clearly, financial institutions are a major part of the investible universe for us and big issuers in terms of the front end and where we're very active historically so it's been great to check the pulse and hear your thoughts, so really appreciate joining me today and we'll look to connect again with you in future episodes. Thanks, Mu.

Mu Tang:

Of course, it was my pleasure. Thanks, Mike.

Jeffrey Addis:

This commentary contained or incorporated, by reference, certain forward looking statements which are based on various assumptions, some of which are beyond our control. Opinions and estimates offered constitute our judgment and are subject to change without notice as are statements of financial market trends which are based on current market conditions. No part of this presentation may be reproduced in any form or referred to in any other publication without the express written permission of Merganser Capital Management. For more information, please visit our website at www.merganser.com. Thank you.