US banks (-21.6%) underperformed the S&P500 (-19.4%) in 2022, reflecting fears of an imminent recession. European banks (-3.2%), on the other hand, significantly outperformed the Euro Stoxx 600 (-12.9%) as the war in Ukraine raged and the energy crisis threatened European growth. How can such a divergence be explained?
Banks' revenues come mainly from two sources: 1) net interest income (NII) from loans and 2) fees on financial services.
The rising rate policy, as determined by central banks, allows banks to improve their revenues but are often accompanied by pressure on margins due to higher turnover of bank deposits, as customers choose to move their accounts to banks offering better returns. Margins could also be affected by a decline in lending volumes caused by the economic downturn.
Since the Covid-19 pandemic, massive deposit growth has flooded banks with excess liquidity. A significant portion of these funds has been placed in non-interest-bearing accounts. These low-interest or "free" deposits have allowed banks to fund themselves at historically low levels. The percentage of non-interest-bearing deposits is starting to decline (see Fig. 2) but remains above the average of the last 12 years and 500 bps above the 2020 low.
With the Fed in tightening mode since March 2022, asset/liability management (ALM) is back in focus. (Rate changes alter cash flows, introducing risk to projected earnings. In addition, these rate changes affect the economic value of a financial institution's equity. Hence the increased importance of balancing assets with liabilities.) With the ratio of loans to deposits at its lowest level for several decades, the level of liquidity on the balance sheet is high. The need for funding is much lower today than in past cycles. The excess liquidity should therefore provide banks with more flexibility to decide whether to increase deposit beta (increase in return on deposits vs. increase of FED rates) or let deposits go to the competition. Competition for deposits is significantly stronger for online banks than for large banks (see Fig. 3). Digital banks, such as Ally Financial, are the most exposed to the risk of deposit beta and may experience more competition and pressure on their margins.
Higher interest rates are often accompanied by a deterioration in consumer credit and a rebound in bad loans (see Fig. 4). Banks must then increase their reserves, which weighs on their net income. The likelihood of having to strengthen their balance sheet through a capital increase increases and their profitability decreases.
In 2022, investment banks suffered from the decline in stock and bond markets, even as M&A activity slowed sharply. Some banks, including Goldman Sachs, are already announcing cuts in staff or bonuses. Analysts, in their worst-case scenarios, expect net income to contract by around -53% (see Fig.5)
Our scenario foresees a difficult start to the year. The recession that is taking hold is likely to weigh on household and business incomes. It is therefore very likely that credit card defaults or the rate of nonperforming loans will rise (see Fig. 6).
Banks have started to report their results for the fourth quarter 2022 and are all very cautious about 2023, increasing their reserve levels. However, this increase is partly linked to a change in the way credit risk is accounted for. The regulator now requires them to recognise losses upfront, when new loans are underwritten. The poorest households have already exhausted their covid savings and loan applications have accelerated. It remains to be seen whether this normalisation of credit indicates renewed consumer confidence or difficulties in making ends meet... So we will have to watch for any increase in defaults on mortgages, car loans and credit cards, and the amount of money banks have to set aside to cover these losses when the loans mature. The accounting change imposed on US banks this year adds to the confusion for investors. Finally, surprisingly, and despite cautious words, JP Morgan is about to increase shareholder returns through share buybacks. A surprising announcement if the economy does indeed enter a recession and the financial health of US households weakens.
The investment banking business remains challenging, as fees from trading and quotation advice continue to suffer from difficult market conditions, which also reduce demand for new debt and equity underwriting. Bond and foreign exchange trading have boosted results, but equity trading is still weak. Wealth and investment management will contribute to growth, but many see a slowdown.
Since last year, European banks have outperformed US banks (see chart of the week). Is this the end of a decade of disappointments and questions about a sector where institutional investors seemed to have thrown in the towel?
US banks were quicker to build up their capital after the great financial crisis. Moreover, mortgage risks were not borne by banks but by government-sponsored enterprises (Fannie Mae and Freddie Mac). They also benefited from a laxer regulatory framework under Donald Trump (e.g. Economic Growth, Regulatory Relief and Consumer Protection Act / May 2018) as well as a massive tax cut. However, all these catalysts are disappearing under the Joe Biden presidency.
European banks, on the other hand, have been slower than US banks to recover from the financial crisis, held back by the burden of their non-performing loans and the adoption of the Bale III regulatory framework imposed by European regulators. Banks have strengthened their balance sheets and risky assets are no longer a burden on capital (see Fig. 7).
Despite fears of a deeper recession in Europe, the quality of bank lending is not yet showing signs of deterioration. The effects of the energy crisis and the market correction following the invasion of Ukraine are not yet visible on the financial statements of European banks. They are compensating for the economic slowdown with better income from loans. They will announce their annual and Q4 2022 results early February. Like US banks, they will most likely disclose that they have increased reserves but that their balance sheets remain stable and strong.
Banks are the first to feel the weaknesses of the economy and to be able to take measures to reduce the impact on their results. The valuation ratios of European banks still indicate a degree of scepticism from investors, although their capital and liquidity ratios have been strengthened and protect them in the event of a disaster scenario. In light of this , they could continue to outperform US banks.