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Street Talk | Episode 122: Banks’ Q4 results bring shades of ‘95 not ‘08, show credit digesting higher rates


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Listen: Street Talk | Episode 122: Banks’ Q4 results bring shades of ‘95 not ‘08, show credit digesting higher rates

U.S. banks’ fourth-quarter 2023 earnings demonstrated continued pressure on funding costs and minimal slippage in credit quality. The Street largely took the results in stride, but management teams were hopeful that net interest margin pressure could subside in the second half of 2024 and credit quality would hold up in the face of a higher for longer rate environment, according to Gerard Cassidy, co-head of global financials research at RBC Capital Markets. In the episode, the veteran analyst said he shares that optimistic outlook and believes the current environment is more similar to 1995 when the U.S. economy digested sharp rate hikes by the Federal Reserve and likely will not result in a severe downturn like some investors fear. Cassidy believes bank stocks are a show me story but does see further catalysts on the horizon. The analyst also offered his outlook for bank M&A activity.

Banks' Q4 2023 results bring shades of '85, not '08

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Street Talk | Episode 122: Banks' Q4 results bring shades of '95 not '08, show credit digesting higher rates

Table of Contents

Call Participants.............................................................................................................. 3

Presentation.................................................................................................................... 4

Question and Answer...................................................................................................... 5

Call Participants


Gerard Cassidy

Nathan Stovall

Unknown Speaker


Unknown Speaker

Welcome to Street Talk, S&P Global Market Intelligence podcast that offers listeners a deep dive into issues facing financial institutions and the investment community.

Nathan Stovall

I'm Nathan Stovall. And on this episode, we're talking about fourth quarter bank earnings season and what results tell us about the health of the group and the economy broadly as well as what they suggest about current valuations and bank strategies going forward. Coming back on the show is a veteran in the sell side, Gerard Cassidy, Co-Head of Global Financials Research at RBC Capital Markets. Gerard, thanks coming back on the show.

Gerard Cassidy

Thank you for having me, Nathan.


Question and Answer

Nathan Stovall

So really at a high level, what are your key takeaways for Q4 earnings? And were there really any surprises in your mind coming into what you were expecting heading into the season?

Gerard Cassidy

It was interesting, Nathan, because there was no big shocks, positive or negative. Of course, you had the negative onetime items with the FDIC charges, but they were well telegraphed. But in terms of the actual numbers, generally, the numbers were in line to slightly better than expected.

You could argue that credit, though it received a lot of headlines during the year on commercial real estate office in urban markets, that's not a big, big risk for the banks in our view. The consumer side of the equation, in the low FICO score consumer, that credit deterioration is continuing. But generally, other areas of consumer credit are okay and corporate credit is actually quite good.

So when you look at the big drivers of bank profitability, credit quality and net interest income, there wasn't too many surprises in either of those areas. Now the big news, I think, though, on the fourth quarter results was the discussion of the inflection in net interest revenue that the banks expect sometime between the end of 2023, and the middle of 2024.

And if we do have a soft landing in the economy and the fed is truly finished raising short-term rates and even cut fed funds rates in 2024, that's going to be very positive for the net interest margins for the banks as well as net interest revenue. So the inflection points, which were discussed, I think, lead investors to look to a stronger second half of 2024 versus the start of the year.

Nathan Stovall

And I want to pick up on that last piece there and really focused on funding. The asset side is moving up a little bit as things are turning over. But we've continued to see funding costs, deposit cost continue to go higher and the mix shift into higher cost funds. But perhaps that was expected. Do you think that what we saw come as expected? And maybe even the bigger takeaway is what you just ended with, the guidance. That the idea that we are going to see some of that pressure ease in the view of management teams in the second half of the year?

Gerard Cassidy

It was expected, to your point. You laid it out well. And I think when you looked at the fourth quarter numbers, most of the banks did not miss on the net interest margin from consensus or our estimates? Even in many cases, they were down. So I wouldn't want to leave the impression that there wasn't pressure. There was, but it was expected, and it didn't come in worse than expected. Most of them were better than expected.

But the key point, I think, going forward is what you touched on. Funding costs are starting to stabilize because the fed last raised interest rates, believe it or not, in July of last year. And what we have seen in the last 4 tightening cycles is there comes a time, generally around 6 months after the last fed funds rate increase, where funding costs for banks start to stabilize.

Because when you think about it, the interest-sensitive deposits, the high-net worth deposits or the noncommercial operating deposits, they have all repriced. As long as the fed doesn't raise rates further, they're not going to reprice higher. So now it's really the shift from noninterest-bearing into interest-bearing that would cause your deposit costs to go higher on a sequential basis. And the banks are telling us that has really slowed down.

So I think what we could see is a flattening in the funding costs over the first 6 months. But to your point, on the asset yields, the banks are now taking the proceeds from the paydowns on bonds and loans and putting them into new securities, the new loans with higher yields. So the margins, that's getting back to the inflection point, I think the margins start to expand possibly as soon as the first quarter or mostly in the second quarter and the second half of the year because of this phenomenon.

Nathan Stovall

And one of the things, too, about the larger guys that you talked about. I mean, their funding dynamics are a little bit different than maybe some of the smaller institutions. And I'd point that out that it could be positive for them in the sense that they've already kind of felt the pain of that repricing, because we even heard some banks talk about how the consumer side might be a little bit stickier on the way down, in part, because we've been so relying on CDs and things like that.

But the big guys aren't as much reliant on that. So they might have a little bit more of a lever to pull. I don't know if you agree with that or not, but that was one of the things I heard from calls that I thought was interesting. The different dynamic in the deposit or behavior between commercial versus consumer.

Gerard Cassidy

That's true, because on the way up, the deposit betas, on the way up, for companies that had the large exposure to commercial deposits, nonoperational deposits or even those high-net worth deposits, they were forced to raise their deposit rates more aggressively than a bank that has a concentration of low-cost consumer deposits.

The best extreme example I can give you is, on one hand, you look at the custody banks like Bank of New York or State Street, their deposit betas are close to 70% to 75%. The incremental deposit betas are at 100%, meaning the last fed fund rate increase, they essentially passed on 100% of that to their depositors. Their depositors, as you know, are financial institutions.

On the other end of the spectrum, we had Regions Financial, they have a very strong consumer deposit base and their deposit betas are much lower than the custody banks'. So you're right, if we get into a period of short-term rates falling, then you are going to see the banks that had the highest deposit betas experience the biggest decreases in funding costs because they've raised deposit rates so quickly.

They are just as quickly going to start to lower them when the fed funds rates decline, whereas the banks that really didn't have to push their deposit rates up, and again, most of these are the banks that have great, strong consumer deposit bases, they won't be able to lower their deposit rates as much because they didn't increase in the as much on the way up. And as a result, there's just less room to cut.

Nathan Stovall

On the credit piece, you already spoke to some of this and talked about the different components and the fact of office CRE kind of taking up the volume or taking up the attention of everyone and getting all the headlines. But as you noted, it doesn't seem like there's a lot of cracks in the armor thus far. I feel like we're all kicking the tires, looking for something, but it just feels like more of that normalization trend the bank management teams have talked about. Did you see any outliers? Did you see anything that makes you feel differently about it?

Gerard Cassidy

We did, Nathan, and it's interesting because the period that we're in today, and we don't know what it's exactly going to look like over the next 12 to 18 months, but it is starting to shape up very similarly, we think, to 1995. And back then, Federal Reserve Chairman, Greenspan, took short-term interest rates up from 3% in February of '94 to 6% in '95. And we all thought a recession was coming because when rates go up that fast, that's normally what happens.

That didn't happen, obviously. It was the so-called Goldilocks economy is what they called it or soft landing. But during that period, the net charge-off ratio for the industry continue to go higher. Nonperforming assets or nonperforming loans were, essentially, flat to down, but the normalization trend took place, and the banks handled it very, very well.

So I think what you're going to see, if we don't have any real shocks to the economy in the next 12 to 18 months, we are going to see these charge-offs normalize and move higher. That's not going to be too much of a surprise. But we don't expect to see any surges in nonaccrual loans or nonperforming assets.

Now there are the pockets which you touched on, the downtown office space is still a problem, and there's going to be some significant losses in certain properties that are 50% or 60% vacant. We also have [ seen ] debt, higher losses in the consumer area on the low FICO score. But other than that, the normalization trends should be very manageable for the banks. And there was no real outliers in the fourth quarter of anyone having a real shock on deterioration. We just didn't see it.

Nathan Stovall

Do you think that's reflected in valuations at all? I mean I heard that investors have sort of moved on from liquidity and are more focused on credit right now and some of those headline issues you just talked about. And we have seen the group rally from the lows, first in the summer and then again in the fall, but multiples are still pretty low.

And looking at it relative to the broader group, they still seem pretty low. To me, it doesn't seem like the Street is still waiting for a shoe to drop, so to speak. So one, do you think -- do you agree with that? And two, do you think that management teams were able to get any more buy-in from the investment community broadly?

Gerard Cassidy

It's an interesting observation because you're right, the valuations, to us, still look very attractive from the banks, especially if you compare it to the market in general. The relative valuations are extremely attractive. That's partly due to the market being up so much as well. Like, I think that the issue is, particularly amongst the long-only investors, as we all were shocked about what happened last March.

And that scar tissue, it takes a while to peel away and burn off and it's gradually burning off in view of the fact that those failures were idiosyncratic and everybody sees that now based upon the time lapse that has taken place from the failures to where we are today. But you're right. I think the issue is definitely more credit now, not liquidity. And everybody is not convinced that we're not going to have a recession.

So until there's further evidence as the year progresses, that we truly are going to have a soft landing, then I would suggest that's probably going to be when more of the long-onlys finally come in and start buying the bank stocks. I would suggest that they were generally very under-owned going into the second half of 2023 because of that scar tissue.

Now as you pointed out, the stocks have rallied off of those October lows and the trading activity would suggest the long-only community has started to buy into the banks. But they're not fully invested yet. They're not up to a full position, we don't believe. And therefore, there is still more buying power on the sidelines.

And I see that coming in once those investors are convinced that credit is not going to be a major issue. Because as you [ and I ] know -- both know, Nathan, so many investors, the only credit cycle they went through was '08/'09. And that was a highly unusual credit cycle, the worst in our careers, and that's not normal. And we're not -- I would be shocked if we saw that. Again, it's just not going to happen because of the changes that have been made to the banking system.

So people want to see the whites of the eyes to make sure that they don't get caught in a situation where bad credit does show up and the stocks get hit hard. So it's a wait-and-see on the economy and then it's a wait-and-see on credit, making sure that it is manageable, this normalization, and it doesn't turn into credit deterioration like we saw in 1990 or in 2008/2009.

Nathan Stovall

It's funny you say that because I have brought up that same comparison of just feeling a little shell shocked even still since GFC and the pandemic, perhaps unfairly cast the group a little bit in there, too, because it was kind of the credit cycle that never was. Amazing what happens when you throw $5 trillion, $10 trillion at a problem.

But the group kind of went back there for a second. Everybody thought, "Oh, they're going to have it happen again." And we haven't seen it. So it's -- I'm hearing you say it's kind of a classic show-me story. We have to have another couple of quarters of just not big problems.

Gerard Cassidy

I think you put your thumb right on it. It's a couple of quarters and investors recognize that, yes, there are cycles that are not going to be as bad as the last cycle. And once they see those -- I envision the stocks really making a run because many of these investors will pile in around the same time, similar to what we saw from October through December in that strong move that the bank's had.

But it is a show-me story. And it's -- I mean, it's not totally out of left field why it is a show-me story because the industry, it's an opaque industry, meaning you and I don't know exactly what's on the books of these banks. We don't know who the top 100 borrowers are for JPMorgan Chase or Bank of America.

If we had that kind of information, then we could say, okay, we're confident that they're not going to have any credit problems because they don't have exposure to high-risk borrowers, let's say. So as a result, it's unfortunate, but it is a show-me story, and we happen to believe that they will show investors that it's not a bad credit cycle, and therefore, the stocks will work as that becomes more evident.

Nathan Stovall

Two things somewhat related to that kind of in closing around how we're seeing banks take action today versus basic blocking-and-tackling. And the first being on kind of cleanup trades. We've seen a handful of, call it, modest restructuring of bond portfolios and even a handful of loan sales. And I've kind of been looking at it.

We've been asking that question if we would see that for some time, selling underwater low-yielding assets and getting ready to move on. I felt like you saw some banks doing it saying, "We're not getting paid for our earnings fully, so we might as well go ahead and take the cleanup trade now." Do you think we'll see more of that?

Gerard Cassidy

It's an interesting point because, I think, there is going to be some of that coming. It's not completely over just yet. And part of the reason, I think, is because of the high capital levels. So banks that have these high capital levels. And because they have these high capital levels, they have to do something with it, whether it's obviously growing the organic business is what you want all the banks to do with their capital, but if growth is modest, then you could use it to return capital to shareholders through buybacks and dividend increases.

But in view of the changes that are coming with Basel III Endgame, banks are a little hesitant to go on the buyback trail until they have a better understanding of where their capital ratios will be. And they may choose to use some of the excess capital to do what you pointed out, which is a bond restructuring. And there's no -- there's a debate whether they're positive or negative, restructuring the bonds.

And if you look closely at JPMorgan's numbers throughout 2023, they were restructuring the bond portfolio throughout the year. But because of the strength in their revenues in net interest, in income and other areas, they were able to handle it without much trouble at all. And so there is some benefits to doing it, of course. You obviously sell off the lower-yielding bonds, take the loss, recapture that loss over a period of time with the higher-yielding bonds.

The hard part, of course, is the timing. Because when you redeploy the funds into higher-yielding bonds, you have to make the decision that yields are not going to go much higher. Because back in the mid-1990s when this is a popular strategy, many of the banks, unfortunately, didn't time it very well and had to do it multiple times in a calendar year, which obviously did not play out well.

So I think we will see some. If the long end of the curve stays in the 3.5% to 4.25% range, probably see less of it. If longer end yields go to 5%, north of 5%, maybe we'll see more. But the focus and the fear of unrealized bond losses and available-for-sale and held-to-maturity portfolios that was at a fever pitch last March because of the Silicon Valley situation, that has died down dramatically, especially up in the fourth quarter bond run that we had, which reduced a number of these unrealized losses, so it's not as much of a topic today. Don't get me wrong. It's not that it's ignored. It's just not front and center like it was 9 or 10 months ago.

Nathan Stovall

Sure. While in the topic, it still might not be front and center because it's been so slow, but just in closing on M&A activity, and I know the absolute biggest guys can't really do anything. The deposit cap prevents them to do so. But what about the next group down on that regionals? We started to hear some talk about we might see some opportunities pop up. What are your expectations there? Do you think we see a fall there? Do you think we see bigger deals? Or if a rebound comes, if it's more of just smaller community banks getting together?

Gerard Cassidy

I think it's going to be a combination of both. And as you and I have chatted in the past, back in 1980, we had 18,000 banks [ in turfs ] in this country. We're down to about 4,600 today. So the long-term consolidation trend is still in place. It has its ups and downs, and we're in one of these periods where it has slowed down. And so what we need to see happen, in our view, for it to accelerate, and it will accelerate. It's just a matter of when.

Number one, we need to see the interest rate marks have less of a negative impact on the asset side of the balance sheet of the target. So when a buyer goes in, they're going to mark the balance sheet to market. And because of the higher interest rate environment today versus the yield in many of those portfolios, both bonds and loans, there's a large unrealized loss mark due to the higher rates.

So as time goes by, those lower-yielding assets pay off, of course. So even if rates don't go down, the interest rate mark does get reduced by the fact that those lower-yielding assets are paying off. If rates were to fall, the fed cut short-term rates, let's say, 100 to 200 basis points over the next 18 months or so, that will also help on the interest rate mark. So that's obstacle number one.

Obstacle #2 is the Basel III Endgame capital ratios, the buyers, the big regionals as well as other banks really don't know where their capital levels will be just yet. Once those proposals are finalized, which we think will happen in the second half of this year, that will take that obstacle off the table, because then the potential buyers will know where they'll be on the capital side.

And then it comes down to, like it always does, banks are sold, they're not bought. And you're going to need to have to find CEOs that are willing to give up their jobs and sell their bank or boards of directors and the CEOs willing to give up their jobs to sell the bank. We will see it. We're going to see it amongst, I think, the big regionals, maybe we get more mergers of $200 billion in asset banks, but also the community banks.

We see banks with anywhere, some $500 million billion being acquired. So the consolidation trends are still in force. There have been a temporary pause, and we think that pause will probably be lifted much bigger in 2025 than in 2024, because of the interest rate mark issue, and because Basel III Endgame, we'd probably get the final resolution to that the latter part of '24.

Nathan Stovall

And I wonder, if you agree, would that be another leg, another catalyst for the group, the first being that a couple of quarters of credit not kind of blowing up, getting more [ comfortable ] of the group, that's sort of happening in the second half of '24. And then if we have this rebound of M&A, call it, in '25, as you just said, is that another boost that could bring capital to the sector?

Gerard Cassidy

It's going to be interesting. In the old days, Nathan, if you would have asked me that question in 1995, 1997, absolutely. You buy a basket of takeover targets, and we did -- which we did recommended to investors, and we all did very well. But the accounting rules back then were different. You were allowed to use pooling of interest accounting that's long gone, and now you have to use purchase accounting, which makes it more difficult to pay very high premiums.

So for the smaller banks, there still will be nice premiums paid, where you could see the stocks rise, maybe 20% on the day of an announcement. But for the bigger banks where there will be mergers, there won't be much at all in premium. So in fact, that may -- when you announce 2 big banks getting together, mergers of equals as they're sometimes referred to, don't necessarily work very well following the announcement.

And so that may even force people to leave certain banks after deals are announced, should they be announced, and go into other names. But it will attract attention, but in terms of outsized gains, because of the consolidation, if they do arrive, I think they'll be limited to the smaller cap stocks, smaller cap bank stocks rather than the large regionals.

Nathan Stovall

Well, we have catalysts coming for the group before that, so you don't need to wait on that is the good news.

Gerard Cassidy


Nathan Stovall

Well, Gerard, thank you so much for taking the time. We certainly appreciate you coming on the show.

Gerard Cassidy

You're very welcome, Nathan. Thank you. It's always a pleasure. Thank you.

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