Big Banks: The relative winners of a wounded industry

Note: A version of this article originally appeared on LibertyFinancialNews.com in April 2023.

While the acute sense of crisis that has gripped the banking system for the past several weeks seems to have faded, the industry as a whole remains in a precarious position. Although difficulties at regional banks were the proximate cause of the turmoil, big banks saw their share prices punished as well. With diversified balance sheets and ample liquidity, the big banks were never in serious trouble, but investors can expect more clarity about the extent of the damage when­­ banks report earnings later this week.

Still, the banking industry as a whole will be subject to lasting impacts from the short-lived crisis. Fresh calls for increased regulatory scrutiny were triggered by the perception that investors were bailed out during the SVB debacle. Most prominently, the $250K FDIC cap has been called into question, with some seeking to codify the de facto protection for all deposits into law, a move which would increase bank insurance costs. Moreover, the decline in bank lending associated with the recent uncertainty could help tip the economy toward recession, which would further harm bank profitability.

Despite these headwinds for the industry as a whole, the larger banks are better situated than their smaller counterparts. The overconcentration of regional banks in certain loan categories, most notably commercial real estate, could be an opportunity for large banks as small banks pull back on lending. Additionally, valuation compressions resulting from rate hikes or a recession could allow big banks to purchase their fintech competitors for a song, a move that would secure their competitive moat. While banking can expect turbulent waters ahead, the big banks will sail much steadier than their competitors.

New Regulatory Pressure

Fresh regulation is the biggest threat to the near-term investment performance of the banking industry. There are more than $17 trillion in deposits held at banks in the United States, with about $10 trillion of those being insured, according to the FDIC’s most recent quarterly report.1 Removing the deposit cap would therefore increase bank assessment fees by nearly 70%, hurting profitability.

Further, political frustration with bailouts could lead to expanded restrictions on the risk-taking capacity of big banks. Post-2008 regulations already limit the extent to which banks can use their balance sheet to finance trading activity, a fact partially responsible for the volatile bond markets of early 2020, when banks were unable to provide sufficient liquidity. New limitations on financing and loan-making activity could be similarly harmful to both the economy and bank performance. With small banks paring back risks and pulling back from lending, big banks will need to step in and provide financing to viable businesses.

Opportunities in Commercial Real Estate

One sector intimately tied to the recent banking turmoil is commercial real estate (CRE), where regional banks do an outsize share of lending. According to analysis by JPMorgan, small banks have about 4.4 times more exposure to CRE than big banks.2

The most recent Senior Loan Officer survey shows a broad tightening in CRE lending conditions, with over half of banks tightening terms for borrowers, and no banks easing terms.3 Considering this data was collected before the recent banking turmoil, the pullback in lending is likely even more pronounced today.

This could be a prime growth opportunity for larger banks, with their access to a diversified capital base, to step in and provide financing to CRE borrowers at attractive terms. Big banks must be disciplined in their lending, though. If a recession occurs, many CRE issues become cash flow problems, rather than solvency problems. Large banks frequently lack the local knowledge needed to take over a business property in default, leaving them ill-equipped to do anything except sell. Driving business property prices down further would only exacerbate the issues facing the CRE market.

Opportunities in Commercial & Industrial Loans

Big banks could see further growth opportunities in commercial and industrial loans (C&I), a market they are much more familiar with than CRE. According to the Fed, big banks make up about 54% of all C&I lending in the United States.4 Recent legislative initiatives in climate and infrastructure could see an expansion of C&I lending anchored by government funds, a growth opportunity that big banks are well positioned to capitalize on.

As Keynesians know, governments can be the spenders of last resort, so the C&I opportunities that result from new transportation or green energy projects could help banks power through the challenging economic environment ahead. However, as with CRE lending, these opportunities will only be realized if governments do not hamper the ability of big banks to bear lending risk on their balance sheet.

Challenges in Asset and Wealth Management

After the 2008 crisis, new capital requirements pushed big banks toward the asset and wealth management space, where revenue can be earned with little use of the balance sheet. The rise of both fintech solutions and index providers in the 2010s, though, challenged the traditional dominance of banks in this sector.

The long-term trend towards robo-advisors will benefit companies like Betterment and Schwab at the expense of banks with traditional advisor networks. Additionally, the rise of passive investing will continue to accrue benefits to companies like BlackRock, which offers low-cost index ETFs and mutual funds rather than the active strategies preferred by banks.

Big banks have put up surprisingly little resistance in this space, as they seem to be optimizing their legacy revenue streams without mobilizing a strategy for the future. One potential route out is to take a page from Morgan Stanley’s book, which purchased E*Trade in 2020 to acquire a retail trading platform. With rate hikes crushing fintech valuations, big banks could find themselves trying to buy their way out of competition.

Deposit Flows: A Pyrrhic victory?

One common narrative of the regional banking turmoil was that money flowing out of small banks benefited big banks, as depositors moved their cash to too-big-to-fail institutions. While this is true in a relative sense, it ignores the record level of deposits that left the banking system entirely. Many of these deposits flowed to money market funds, which hold cash and other ultra-safe assets.  According to data provider EPFR, over $286B went into money market funds in March, one of the largest monthly inflows in history.5

The big banks still saw some benefit from this trend, as many of them are asset managers for the very same money market funds that saw record inflows. Still, earning 50 basis points in management fees is less attractive than earning five times that in interest margin. In any case, depositors were reminded of the value of keeping their money with systematically important banks, which should help big banks outperform their smaller peers for the foreseeable future.

Recession Risks

Adding to the existing economic uncertainty, the recent lending pullback by banks could contribute to a recession. According to the Fed, bank lending has dropped since March 15th, in the most significant decline of the past year.6 When new loans are not created as quickly as existing loans mature, deposits in the banking system drop, in what is essentially a money-destroying process. This is one of the ways that bank failures contributed to the Great Depression in the 1930s. While the existing situation is not nearly as catastrophic as that, there is a real risk that lending declines amplify existing recessionary trends.

Paradoxically, a slowdown in economic activity as a result of lending declines could end up helping banks, since it would reduce the need for the Fed to raise rates. A secular decline in lending activity accomplishes the goals of rate rises without actually needing to do so. If the discount rate is held steady, the market value of loans and securities held by banks could stabilize – provided, of course, the economic slowdown does not eat into loan loss provisions.

Conclusion

The big banks certainly have some competitive advantages over their smaller counterparts, most notably their ability to draw low-cost deposits. Additionally, there are growth opportunities in both new and existing lending segments, especially as regional banks tighten credit restrictions. However, these strengths shy in comparison to the overarching issues facing banking as a whole. Regulatory issues, fintech competition, and macroeconomic uncertainty make big banks the strongest players in a weak industry.  

Financial Comparison of the Big Banks

Net Profit Margin and Tier 1 Capital Ratio figures are as of Q42022.      

JPMorgan Chase (JPM)

P/E (TTM): 10.63   P/B: 1.42   Net Profit Margin: 23.8%   Tier 1 Capital Ratio: 13.2%

The premium for JPMorgan’s shares likely reflects the bank’s reputation for resilience through multiple financial crises.

Bank of America (BAC)

P/E (TTM): 9.00   P/B: 0.94   Net Profit Margin: 23.8%   Tier 1 Capital Ratio: 12.8%

HSBC (HSBC)

P/E (TTM): 9.44   P/B: 0.74   Net Profit Margin: 15.8%   Tier 1 Capital Ratio: 14.2%

Citi (C)

P/E (TTM): 6.64   P/B: 0.50   Net Profit Margin: 14.7%   Tier 1 Capital Ratio: 13.0%

Citi’s low P/B valuation makes it an interesting value play, but management’s cost-cutting measures over the past several years leave limited opportunities for growth moving forward.

Wells Fargo (WFC)

P/E (TTM): 12.54  P/B: 0.94   Net Profit Margin: 13.7%   Tier 1 Capital Ratio: 10.6%

Barclays (BCS)

P/E (TTM): 5.26  P/B: 0.36   Net Profit Margin: 13.7%   Tier 1 Capital Ratio: 13.9%

Barclays’ low valuation is the result of repeated scandals and the strict regulatory framework of the UK. 

UBS (UBS)

P/E (TTM): 9.32  P/B: 1.15   Net Profit Margin: 22.2%   Tier 1 Capital Ratio: 14.2%

UBS recently acquired Credit Suisse at the behest of Swiss regulators. In a presentation describing the deal, UBS said that the new entity would have a Tier 1 Capital Ratio greater than 13%.

Santander (SAN)

P/E (TTM): 6.5  P/B: 0.65   Net Profit Margin: 10.3%   Tier 1 Capital Ratio: 12.0%

Royal Bank of Canada (RY)

P/E (TTM): 12.38  P/B: 1.79   Net Profit Margin: 24.0%   Tier 1 Capital Ratio: 12.6%

The premium for RBC likely reflects the group’s high profit margin, and the lax regulatory framework of Canadian banking when compared with the US.