Following the Great Recession, the Federal Reserve dropped rates close to zero in 2010 to jump-start the economy. Rates stayed around this level for another roughly seven years, and in that time period, the banking industry changed.
After the fallout from the housing market during the Great Recession, banks originated fewer residential mortgages, likely due to several reasons. There were stricter underwriting standards. Millennials, saddled with debt, didn't buy homes. These loans were also less attractive to banks because they have smaller spreads than many other loan categories.
Instead, banks began to focus on the commercial sector, adding $1 trillion in commercial and industrial loan volume between 2006 and 2019, according to the FDIC, and significantly boosting commercial real estate and multi-family loan volume as well.
Rates began to finally tick up in 2016 and got as high as 2.5% in 2019 until the coronavirus pandemic quickly sent them tumbling back down to zero in March. Now, Fed Chairman Jerome Powell has indicated that rates could stay near zero for another five years. With another sustained period of low rates on the way, following yet another potentially industry-changing event from the pandemic, here are three questions I have for the banking industry.
1. Will banks shift their loan focus?
Many banks that once focused heavily on residential sector have recently leaned much more heavily on commercial loans. But since the coronavirus pandemic struck, there have been a lot of questions about the future of commercial real estate.
The acceleration of digital trends may make office buildings less relevant as more people work from home, and who knows when gyms, movie theaters, and restaurants will truly be back to pre-pandemic levels. Wells Fargo (NYSE:WFC) CFO John Shrewsberry said on the company's most recent earnings call that "commercial real estate prices are forecasted to decline by low to mid-teens with hotel, restaurant, and retail sectors expected to decline much further."
Meanwhile, the mortgage market, at least for single-family homes, has been hanging in there. Since rates fell to zero, there has been a surge of refinancing activity and even a resurgence of purchase mortgage activity, with average mortgage rates on the 30-year fixed product staying below 3% since mid-July, according to Freddie Mac.
Although residential mortgages do have smaller margins than commercial loans, banks can make the business profitable by pumping out high volumes of loans and by collecting fees for servicing the mortgages they sell to the secondary market. While it can be hard to sustain the volume game through years of low rates, I'm still watching what will happen with the residential and commercial loan dynamic.
2. How will banks increase earnings?
With rates continuing to stay low, so will profit margins on loans. Banks have managed to increase earnings over the past decade, but can they continue to keep this up?
Over the past decade, I would have guessed that banks had started to generate more of their revenue from sources of non-interest income. After all, we just witnessed JPMorgan Chase's (NYSE:JPM) investment bank division carry the bank to a profitable second quarter despite setting aside nearly $10.5 billion to cover future potential loan losses. But even though non-interest income in the industry is much higher than it was in 2010, according to the FDIC, it actually makes up a smaller percentage of total revenue than it did in 2010.
So, maybe we'll start to see non-interest income become more relevant in the revenue picture, but I also think you will see cost cutting and consolidation continue to accelerate. If you can't get higher yields on loans, one way to increase the margin is to reduce expenses. The banking industry actually had a better efficiency ratio, a measure of a bank's expenses expressed as a percentage of total revenue (lower is better), in 2010 than it did at the end of 2019.
Although regulatory costs have added up over the past decade, banks have also invested in technology and will continue to do so. With the pandemic heavily accelerating digital payment trends and remote banking, there will be less need for human employees, typically the single largest expense for banks, and branches will be closed or consolidated. Additionally, banks will continue to merge to add scale and save on back-end costs -- there are roughly 2,868 less banks now than there were in 2010, according to the FDIC.
3. Can the momentum continue with deposits?
Despite not offering much of a return on any type of bank account since the Great Recession, banks seem to have been successful at growing deposits. Between 2010 and the end of the second quarter of 2020, deposits at all FDIC-insured banks grew from nearly $9.2 trillion to nearly $17 trillion, and interest-bearing deposits make up less of a percentage of total deposits now than they did in 2010, according to the FDIC.
We know that banks had some of their best quarters most recently as the pandemic brought more than $2 trillion of deposits into the banking system over the past six months. New digital banking technology and unique promotions have helped banks catch the eyes of consumers. I also think the banking industry could come out of the pandemic with a much better reputation considering their work on the Paycheck Protection Program, and given that the current recession did not stem from the banking system. So, I think banks are in good shape with deposits right now.
One area that could be in trouble is high-yield savings accounts. A lot of banks like Goldman Sachs (NYSE:GS) now offer digital savings accounts with a higher annual percentage yield (APY) than most standard savings accounts. There are several options, but Goldman really began to demonstrate the power of its digital bank, Marcus, by bringing in $20 billion in deposits in the second quarter, and increasing its total retail deposits to $92 billion. However, now that rates are back near zero, Marcus is only offering an APY of 0.80%. Perhaps people with larger sums of money may still find this attractive, but it's hard to see this generating much excitement in your standard retail depositor.