Bank returns could fall short of Street expectations, sparking more M&A

The Federal Reserve's plans to raise interest rates and the return of loan growth will boost bank profitability, but the gains might not come as quickly as the Street hopes and that should encourage more bank M&A activity, according to Nomura Managing Director Greg Hertrich.

That was the view Hertrich, head of U.S. depository strategies at Nomura, offered in the latest Street Talk podcast. In this episode, Hertrich discussed how Fed actions will impact bank profitability and liquidity, whether those results will meet current expectations from the Street and how the performance will alter the bank M&A landscape.

The Fed could soon change the operating environment for banks, with Fed Chair Jerome Powell recently signaling that the central bank would begin raising short-term rates in March and suggesting that more increases could follow shortly thereafter as it works to temper heightened inflation. The Fed also plans to significantly reduce its $9 trillion balance sheet over time, and a number of economists and bankers have suggested that the shrinkage and pace of rate increases could be much quicker than in past rate cycles.

Higher rates should boost bank margins, but Hertrich argued that the impact might take longer than some people anticipate.

"You can see a scenario where 2022 is sort of a growth pattern, but it's really 2023 before you begin to see the effects of some of those decisions playing out on income statements," Hertrich said in the episode.

Fed actions could also impact bank liquidity levels, which are at historically high levels and have negatively impacted bank margins. A number of bankers, including executives from the nation's largest bank, JPMorgan Chase & Co. have suggested the balance sheet shrinkage could serve as a headwind to deposit growth or even result in some of the cash leaving their bank.

Hertrich said the Fed contributed to the historic deposit growth recorded during the pandemic by significantly increasing the level of bank reserves in the financial system. Bank reserves ballooned with the growth in the Fed's balance sheet, which more than doubled in size during the pandemic. Hertrich noted that bank reserves and deposits have been aligned and as the Fed's balance sheet shrinks, reserves will decline, and deposits could fall in turn.

However, Hertrich suggested that the Fed balance sheet shrinkage could take quite a while. For instance, if the Fed let $100 billion in securities roll off every month — slightly less than $120 billion in monthly securities it purchased in its bond-buying program — the balance sheet would decrease by $1.2 trillion in a 12-month period. At that pace, it would take more than four years for the Fed's balance sheet to return to pre-pandemic levels.

In that scenario, excess liquidity likely would remain a headwind for most banks unless they are able to record outsized loan growth. Loans began to grow at a quicker pace in the fourth quarter of 2021, and the Street expects strong growth to continue in 2022. Still, Hertrich noted that the competition is fiercer today than it was in prior rate hike cycles due to the influx of financial technology companies, including a number of well-funded neobank entities that are vying for traditional bank customers.

"If you wanted to borrow money today, I'm sure you could simply go to your e-mail inbox and there would be half a dozen offers from non-depository institutions that would be very, very happy to offer you an opportunity to borrow directly from them," Hertrich said. "Banks are competing in a way that they haven't historically, which makes anticipation for lending demand through the banking channel a little bit more of a challenge than it has been historically."

Hertrich said bank investors' and bank managers' expectations for loan growth are probably too "aggressive." While acknowledging that higher rates could lead to stronger bank returns, he said some bank investors might want to see more action from management teams. He said investors could encourage institutions with stronger currencies to pursue acquisitions while pressuring others that face greater challenges to partner with another institution.

"What you really get is a lot of bank management teams are being asked, 'What sign do you want to put out front? Do you want to put a "for sale" sign out front? Or do you want to put a "if you are for sale, call us" sign out front?'" Hertrich said. "I think it is fair to expect continued M&A in the financial space over the course of 2022 and 2023, frankly, probably '24 and '25."

"Street Talk" is a podcast hosted by S&P Global Market Intelligence.

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