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3 Reasons Why the Outlook for Banks Is Better Than You Think

By Dave Kovaleski – Updated Jul 2, 2020 at 10:49AM

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It's going to be a bumpy ride, but banks are prepared for the shocks.

There's no denying that banks have been beaten down pretty hard during this COVID-19 crisis. The average bank stock is down about 37% through the first two quarters of the year and 26% for the one-year period ended June 30. Bank earnings have been hurt by a number of factors, particularly 0% interest rates and large credit-loss provisions to cover the potential for a higher-than-expected rate of defaults, and overall credit risk.

With the ongoing recession and an interest rate environment expected to stay in the 0% range for the foreseeable future, the outlook for banks does not seem great. But there are some positive signs that indicate the forecast may not be as bleak as you might think.

1. Rainy day women, and men

In its first-quarter report on the banking industry, the Federal Deposit Insurance Corp. (FDIC) noted that the industry saw a 70% drop in earnings compared to the previous year's quarter. But community banks fared better, suffering only a 21% drop in earnings. This was primarily due to lower credit-loss provisions for smaller banks, which aren't yet required to meet the new current expected credit loss (CECL) standards.

The front steps of a bank with large stone columns out front.

Image source: Getty Images.

But there was a silver lining for banks during the pandemic as deposits surged to $15.3 trillion at the end of May, up 20% over the previous year's May. In the month of May alone, deposits grew by about $860 billion -- the biggest one-month spike ever.

This was due to the federal government providing loans and stimulus to businesses, combined with businesses and families hoarding cash due to the pandemic. Also, large banks in particular made defensive draws on lines of credit that didn't get spent, so that added to deposit levels. Deposits have continued to climb through June and that has helped banks with liquidity when they really need it for the rainy days ahead. "Any time that the banks have an excess of deposits, that's a good thing -- especially in a crisis, liquidity is important," said Brian Klock, managing director and bank analyst at Keefe, Bruyette & Woods.

Deposit levels will start coming down as people get back to work and start spending money in the economy. This is especially true for larger banks. But smaller banks might see a boost in deposits, as they made defensive draws in the second round of PPP loans, said Klock. Also, look for banks to continue to lower deposit rates with so much extra cash.

2. Passing the stress tests

The Federal Reserve recently released the results of its 2020 stress test, and for the most part, banks' balance sheets held up pretty well. In the words of Fed Vice Chair Randal Quarles: "The results of our sensitivity analyses show that our banks can remain strong in the face of even the harshest shocks."

The Fed started with its usual regular test, which assumed a severe global recession where unemployment would peak at 10% and GDP would fall 8.5% over the course of the test period. In that test, designed before the pandemic, banks were "strongly capitalized." It also did a more stringent sensitivity analysis based on hypothetical scenarios related to the COVID-19 crisis with unemployment rates reaching a high of 19.5%. One called for a V-shaped recovery; another was based on a U-shaped, more drawn-out recovery; and the third assumed a W-shaped, double-dip scenario. In all three scenarios, banks remained adequately capitalized. In the sensitivity analyses, according to the Fed, aggregate capital ratios "declined from 12% in the fourth quarter of 2019 to between 9.5% and 7.7% under the hypothetical downside scenarios. Under the U- and W-shaped scenarios, most firms remain well-capitalized, but several would approach minimum capital levels."

To ensure that banks remain resilient, the Fed suspended share repurchases and capped dividend payments in the third quarter, and required banks to reevaluate their longer-term capital plans. But it's clear that the more stringent capital requirements established by Dodd-Frank have helped banks build up enough equity to survive an economic shock. Only one major bank, Wells Fargo (WFC -1.04%), is cutting its dividend in the third quarter, and Klock doesn't expect any others to follow suit.

3. Expense reductions

Banks are going to be earnings-challenged over the next few years due to 0% interest rates, a decline in loan growth, and credit deterioration. These conditions have forced banks to reduce expenses, and these cuts will continue over the near term. The pandemic has shown banks that they can do more with less, which, unfortunately, will lead to layoffs -- but also remote work, more reliance on technology, and reductions in real estate footprints. Those savings will help keep banks profitable through this recession. Klock sees earnings cut in half over the next two years, but he does expect banks to remain profitable.

So, the outlook is certainly not rosy, and there are other industries that will outperform banks, but it may not be as dire as some think. Most banks are positioned to navigate the downturn, and some will perform better than others and provide good long-term value.

Dave Kovaleski has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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