World Economy

Bank Investors’ Patience Slowly Running Out in US

Bank Investors’ Patience Slowly Running Out in USBank Investors’ Patience Slowly Running Out in US
Interest rates are rising and money should be rolling in. But the story isn’t playing out like the bank executives said it would, and investors are taking notice

One could excuse bank executives for being a little perplexed by their investors. JPMorgan Chase & Co., Citigroup Inc. and Wells Fargo & Co. all reported earnings that largely beat expectations. But shares of all three slumped soon after the market opened Friday.

For the past few years, those executives have been spinning the same story. Revenue and profit growth has been slow, but just wait until interest rates pick up. Then everything will really take off. It’s not us. Its interest rates (and the Federal Reserve), Stephen Gandel wrote for Bloomberg.

Investors appeared to have bought in. Shares of banks are up 90% in the past five years. Investors have particularly taken to the big banks this year, thinking that tax cuts, a robust stock market and generally good business vibes—broadly  defined as the Trump Bump—would pay off as more consumers and businesses increased borrowing. JPMorgan’s shares now trade at 1.7 times their book value, which seems to indicate investors expect high returns. Most of the big banks’ stocks traded for less than their book value after the financial crisis.

  Reasons for Disappointment

Now interest rates are rising and the money should be rolling in. But the story isn’t playing out like the bank executives said it would, and investors are taking notice. The banks don’t seem to be getting the benefit from higher interest rates that investors once imagined they would. Yes, interest income rose more than 10% in the quarter for JPMorgan and Citigroup, but interest expenses were up in the 50% range.

Investors can point to three reasons for disappointment. The first is loan growth, or rather the lack of it. Low unemployment and a continued rising economy and stock market, especially in an expansion as long as this one, should produce a surge of lending.

The tax cut was supposed to amplify that jump. Instead, lending at the largest bank, JPMorgan, rose just 0.2% in the first quarter from the previous three months. Wells Fargo’s loans dropped by 1%, though some of that can be attributed to the bank’s particular problems. Citigroup’s lending was up 1%, but that stemmed largely from a push to expand its credit card business, which hasn’t been going so well.

In the first quarter, the bank had to increase its provision for losses in its retail-branded cards by 16%. Yes, analysts were predicting that lending would be relatively weak, but it was even weaker than many forecast.

Second, higher interest rates were supposed to translate into much higher lending profits. That isn’t the case, either. Part of the explanation is that long-term interest rates haven’t risen as much as short ones, compressing the lending profit spread.

But banks also appear unable to hold onto as much of the benefit of higher short-term rates as expected. They have had to pass along some to consumers, who are their lenders. Net interest margins, which used to be in the 5% range, are still stuck in the 3% range.

Third, higher interest rates were also supposed to lead to more profits in the buying and selling of bonds, which used to be a chief driver of the big banks’ profits. Volatility was up in the first quarter, and many expected that would translate into big trading profits. But it didn’t, at least on the bond-trading side. Equity trading was a bright spot, but that’s never been a big profit center.

The higher-interest-rates-equal-higher-profits story was flawed from the beginning. Interest rates were historically low and stayed that way for so long that many individuals and companies took advantage of the low rates and refinanced. Many companies seemed to borrow more than they needed. Now that interest rates are rising, there’s no great demand for borrowing. The banks’ mortgage businesses weakened during the quarter.

  Negative Feedback

There is also something of a negative feedback loop taking place. Bank stocks have traded up on the idea that the improving economy would produce more borrowing. It has not. So perhaps the problem is that the economy is not as good as people think.

A sinking economy will take the banks with it. Bank executives are once again telling investors they just have to wait. “As much as we’re all eager to see the benefit,” JPMorgan CFO Marianne Lake said during a conference call with analysts about the boost from the tax plan, “We have to recognize that tax reform is still in its early stages.”

Bank investors’ patience is running out.

The US Federal Reserve minutes released last Wednesday show that central bank officials are increasingly committed to raising rates and shrinking the bank’s balance sheet. While economic signs remain mixed, continued growth, rising inflationary expectations, tightening labor markets and the need to temper asset prices would all seem to argue in favor of higher rates.

Other central banks are likely to follow. The Bank of England and the European Central Bank have foreshadowed normalization of interest rates. The ECB seems likely to scale back its bond purchases. Markets are now factoring in multiple US interest rate rises in 2018. The yield on the 10-year US Treasury note has risen from 2.4% to 2.8% in 2018 alone.

Rising rates seem like a valedictory return to “normality”—a marker of how successful the central banks’ heroic actions to counter the Great Recession were. What the celebration misses, though, is how swelling levels of debt will amplify the effect of any rate rises.

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