The U.S. banking industry could see earnings drop by nearly 25% in 2020 as net interest margins contract and credit costs rise, according to S&P Global Market Intelligence's 2020 U.S. Bank Market Report. The recent sell-off in bank stocks suggests that investors see a high likelihood of that occurring.
Fears over slower economic growth resulting from the outbreak of the coronavirus prompted two emergency rate cuts by the Federal Reserve and pushed long-term rates to new historical lows over the last month. Banks stocks have taken considerable hits as well, dropping nearly 40% since mid-February, leaving the SNL U.S. Bank and Thrift index trading at about 115% of tangible book value, compared to the one-year average of more than 170%.
The lower multiple implies that book values could decline, or at least will not be bolstered by strong earnings. Bank earnings should drop materially as the flat-to-inverted yield curve will put further pressure on margins, while credit costs will jump due to the notable slowdown in business activity related to efforts to contain COVID-19, according to S&P Global Market Intelligence's annual outlook for the industry.
Credit costs poised to jump from low levels
S&P Global Market Intelligence expects the credit environment to deteriorate notably in 2020, with a number of economists predicting that the U.S. economy will contract severely in the second quarter as businesses slow production or even shut down in order to contain the pandemic.
While the slowdown was originally expected to be most pronounced in China where the novel coronavirus first surfaced, a number of economists now fear an even greater decrease in GDP in the U.S. Many economists are now predicting that efforts in the U.S. economy will lead to a contraction in the second quarter and possibly for the full year. Deutsche Bank and Bank of America have projected low double-digit contractions in the U.S. economy in the second quarter of 2020, while Goldman Sachs believes GDP could drop as much as 24%. Such a decline would be far larger than any contraction witnessed in the U.S. during the Great Recession.
Economists have pointed to social distancing measures that spurred closures in many offices, schools, manufacturing plans and stores. Thousands of retail stores and restaurants have already closed their doors. Their revenues have evaporated after various cities, counties and states have established restrictions on dining at physical locations and on leaving home at all. The moves have already spurred layoffs, and economists fear far more are on the way.
Concerns over contracting the virus will also lead to reduced tourism, and airlines and hotels have already reported sharp reductions in bookings. Business travel will also decline, with a number of sizable U.S. companies banning nonessential business travel and canceling large conferences, and much of corporate America asking their employees to work from home.
Economists' and investors' expectations for significantly slower global growth have been reflected by the dramatic flight to quality in the bond market, which sent the yield on the 10-year Treasury well below 1% for the first time ever. Spreads in the high-yield market have widened considerably since volatility erupted in the markets. If dislocation persists, more companies could face downgrades and end up in junk status, and those firms and other levered companies likely will find it more challenging to roll over existing debts.
That could include a number of companies in the oil and gas sector, which had already faced weaker demand due to the expectation for slower global economic growth. Headwinds to the oil and gas business only grew after Saudi Arabia initiated a price war, sending oil prices down to the mid-$20s, levels that are not profitable for a number of U.S. exploration and production companies. The credit default swap market suggests that many of those firms now face a fairly high risk of default.
S&P Global Ratings has warned that ratings actions on investment-grade oil and gas companies could be more severe compared to the previous down cycle in oil prices a few years ago, noting that producers are unlikely to achieve the same level of efficiencies.
Weakness in the oil and gas sector and travel and hospitality industries could reduce business spending even more. The reduction in activity will come after nonresidential, private fixed investment had already declined for three straight quarters through the end of 2019. Some economists have said four straight quarters of reduced capital expenditures would suggest that a downturn lies on the horizon.
The Fed has responded to the unprecedented demand shock and business closures with rate cuts and a number of liquidity facilities aimed at shoring up confidence while maintaining orderly functioning of the wholesale funding markets. The U.S. Senate has also reached an agreement on $2 trillion in stimulus that would increase hospital funding, guarantee unemployment insurance payouts of 100% of salary for most recipients and provide $350 billion in relief to small businesses.
While the slowdown in the economy likely will be sharp, many economists still expect a rebound in activity in the second half of 2020, in part due to federal efforts to mitigate the impact of the coronavirus crisis. Still, banks will have to build reserves notably in 2020 and increase them further in 2021 as loan portfolios season and losses rise. Those increases could be even greater if the most bearish forecasts come true.
Net interest margins contracting over the next few years
In the near term, further decreases in interest rates will weigh on the U.S. banking industry's net interest margin as loan yields will reprice down more quickly than deposit costs.
Deposit costs only declined modestly in the second half of 2019 even after the Federal Reserve cut rates. The deposit beta recorded by the banking industry during the six months ended Dec. 31, 2019, was just 19.9%, demonstrating that banks struggled to lower deposit costs in line with market rates. Comparatively, the deposit beta recorded between the fourth quarter of 2018 and the second quarter of 2019, when short-term rates still moved higher, was nearly 90%.
The deposit betas recorded in the second half of 2019 are similar to the ones seen in past easing cycles. In the recent period, higher-cost retail CDs lingered on banks' books and prevented more substantial declines.
Betas on retail CDs eclipsed 100% in 2019, nearly 3x the level recorded in 2018. Now that rates have declined, banks face a different problem when it comes to retail CDs: The costs have failed to drop. The beta on retail CDs during the last six months of 2019 was actually negative, with rates on those accounts rising during the period despite decreases in short-term rates. One-year CDs are often the most popular product among retail customers, meaning that many institutions could have originated accounts in the late spring and early summer before rates declined.
Banks should benefit as some of those higher-cost CDs mature in 2020 and allow for larger decreases in deposit costs in 2020. The sharp decline in short-term rates stemming from two emergency cuts by the Fed in March 2020 will no doubt help banks drive deposit costs lower as well.
With the fed funds rate back near the zero bound, institutions will work to aggressively lower rates on deposits. However, some of those efforts could be mitigated as institutions feel modest pressure on their liquidity as corporates pull on committed credit lines. The industry had more than $2.5 trillion in unfunded commitments at year-end 2019, and a number of corporate customers have drawn on existing credit lines to shore up cash positions amid the uncertainty in the marketplace.
Taken together, the expected margin pressure and heightened credit costs facing the U.S. banking industry will cause returns to decline notably this year. The drop could be even more severe if some of the direst economic forecasts come to fruition.
Scope and methodology
S&P Global Market Intelligence analyzed nearly 10,000 banking subsidiaries, covering the core U.S. banking industry from 2004 through 2019. The analysis includes all commercial and savings banks and savings and loan associations, including historical institutions, as long as they were still considered current at the end of a given year. It excludes several hundred institutions that hold bank charters but do not principally engage in banking activities, among them industrial banks, nondepository trusts and cooperative banks.
The analysis divided the industry into five asset groups to see which institutions have changed the most, using historically significant regulatory thresholds. The examination looked at banks with assets of $250 billion or more, $50 billion to $250 billion, $10 billion to $50 billion, $1 billion to $10 billion, and $1 billion and below.
The analysis looked back more than a decade to help inform projected results for the banking industry by examining long-term performance over periods outside the peak of the asset bubble from 2006 to 2007. S&P Global Market Intelligence has created a model that projects the balance sheet and income statement of the entire industry and allows for different growth assumptions from one year to the next.
The outlook is based on management commentary, discussions with industry sources, regression analysis, and asset and liability repricing data disclosed in banks' quarterly call reports. While taking into consideration historical growth rates, the analysis often excludes the significant volatility experienced in the years around the credit crisis.
The projections assume future fed funds rates and 10-year Treasury yields based on a monthly survey of more than 60 economists conducted by The Wall Street Journal. Figures for the fed funds rate and 10-year Treasury yield through 2022 are based on three-point averages including estimates provided in that survey. The 2023 figures blend estimates from the Journal survey and estimates provided by the Congressional Budget Office, while the 2024 figures are based on CBO estimates. Assumptions for the fed funds rate and the 10-year Treasury yield in 2020 and 2021 were adjusted to reﬂect recent market activity. S&P Global Market Intelligence does not forecast changes in interest rates or macroeconomic indicators and aims to project what the banking industry will look like if the future holds what most economic observers expect.
The outlook is subject to change, perhaps materially, based on adjustments to the consensus expectations for interest rates, unemployment and economic growth. The projections can be updated or revised at any time as developments warrant, particularly when material changes occur.