Banks in 2020: The Good, The Bad, and The Ugly

Banks enjoyed a reasonably prosperous year in 2019; loan growth was mediocre and hopes of a sustained Fed-tightening cycle that would ease margin pressure were dashed but credit remained largely benign and there were mergers large and small, fueling higher earnings and stock prices.

Banks enter 2020 facing cross-currents; some are favorable, some are challenging, and some tail risks appear genuinely unnerving. Let’s look at the good, the bad, and the ugly for banks in 2020.

The Good

Despite the advanced age of this credit cycle and some visible fraying around the edges in areas like auto lending on the consumer side and leveraged lending on the corporate side, credit quality remains quiescent; the median large bank holding company nonperforming asset ratio has remained stable in the 50-60 basis point range for several years now. As long as that remains the case, it limits the downside risk to estimates.

Two favorable secular trends also show no signs of abating:

1. The secular consolidation of the U.S. banking industry appears likely to continue; 2020 could see the total number of U.S. banks fall below 5,000. Sellers’ expectations appear to have adjusted to valuations that tend to yield a premium to sellers, earnings accretion to buyers, and reduced competitive pressure all around. Whether or not that dynamic redounds to the benefit of consumers, it is a robust source of support for share prices.

2. At the firm level, consolidation of branch networks into fewer and smaller branches should continue and, if anything, accelerate. Declining foot traffic continues to enable banks to realize the largest source of merger savings without having to engage in mergers. The return to a lower-longer interest rate environment mitigates the potential deposit runoff, allowing banks to be even more aggressive on this front.

The Bad

The new Current Expected Credit Losses (CECL) standard for reserves pulls loan-loss reserves forward, creating a material earnings headwind for consumer lenders. However, the accounting treatment has no impact on the cash flows or riskiness of actual loans and all else being equal, a more heavily reserved bank is a less risky bank. As a result, the effect on earnings and ROE should be mitigated by higher multiples of earnings and tangible book value.

Fundamentally, loan growth seems likely to remain generally sluggish. Moreover, the end of the Fed’s tightening cycle implies the potential for increased pressure on net interest margins. While banks are not currently writing off an especially high share of loans, should the aforementioned fraying-around-the-edges persist, at some point bank stocks may begin to discount an elevated risk of a step-up in credit costs.

Moreover, while bank efficiency ratios should benefit from the ongoing reduction of branch footprints, it remains to be seen whether banks’ tech spend will permit much (or indeed any) of the savings to hit the bottom line.

In fact, technology spending has had a historical tendency toward lumpiness in banks (in part because many large investments naturally are the proverbial pig-in-a-python and in part because less than perfectly efficient markets have often rewarded managements for gaming investors’ tendency to look through any expense labeled nonrecurring). Therefore, it would not be shocking to see that the current ferment in the fintech world arrest the efficiency ratio gains of recent years and drive banks toward another ramp-up in technology expense.

Finally, the election is a bit of a wild card. Banks have fared reasonably well thus far under the current administration, although past performance is no guarantee of future results. Certain potential challengers have been rhetorically antagonistic toward banks though history suggests that this presents more headline risk than anything else.

The Ugly

One must always keep tail risks in perspective; by definition, they exist in the tail of the distribution after all. Yet banks face a couple of specific tail risks that are probably best kept on the radar.

The first is the risk that the tech sector turns the banking business into an app, in a manner analogous to what happened to the music industry. At a high level, most of the advantages of incumbency currently enjoyed by banks are highly vulnerable to tech firms wielding a vastly lower cost of capital (sustaining losses while burning through capital to capture market share is not an avenue that is open to banks). Regulation currently forms the best defensive moat the industry enjoys, which seems heartening until one recalls that only a decade ago, the same was true for the yellow cab business.

Should the tech firms currently nibbling around the edges of payments decide to aggressively go after banks’ profits, either through direct competition or by building new business models that effectively reduce banks to the dumb pipes of the financial system, banks and bank investors could be in for rough sledding.

The second is the panoply of macro risks embedded in a financial system that features trillion-dollar fiscal deficits, a rapidly re-inflating Fed balance sheet, the normalization of seven-year, upside-down car loans amid full(ish) employment, and a general perception of prosperity. Ever-greater leverage in balance sheets—public and private—calls to mind former Council of Economic Advisors Chairman Herb Stein’s dictum that “if something cannot go on forever, then it will stop.”

The last time things that could not go on forever finally stopped, the federal government brought its borrowing to unprecedented highs, and the Federal Reserve brought interest rates to unprecedented lows. These were possible without especially painful side effects due to the status of the USD as the world’s reserve currency. Yet no law of God or man establishes that as a permanent condition, any more than was the case for the British Pound or any other currency that once enjoyed primacy.

One can state with certainty that the reserve status of the dollar will prove equally transient. Only the very bold or very foolish would attempt to predict precisely when that day will come, but it seems difficult to believe that the various exertions to extend this cycle a bit longer aren’t bringing that day much nearer. It also seems like a good guess that when it arrives, that day will be in the middle of a financial crisis, at a time when markets are again looking to Washington for salvation.

In such a scenario, the dislocations would ostensibly radiate far beyond the banking industry—indeed, it suggests the desirability of investing in certain uncorrelated asset classes such as canned food and ammunition, despite the paucity of dividends or liquidity—but banks would find themselves uncomfortably close to ground zero.

Each of these catastrophes is exceedingly unlikely to afflict banks in 2020 but they represent real risks of sufficient severity to merit monitoring.

Conclusion

On balance, the outlook for banks in 2020 is looking like “more of the same.” Amid an economic expansion of record length but below-average growth rates, if one were to run a Monte Carlo simulation, the most likely outcome is probably one in which tail risks remain tucked into the tails, credit (and therefore earnings) generally holds up, continued mergers and branch closures mute operating expense growth, and banks thus continue to post reasonably good core growth and profitability.