Banking companies will be some of the main beneficiaries of Donald Trump's election as the president. We have already seen how base metals have responded as the expectation of increased infrastructure spending has resulted in a strong rally in base metal prices. Banking stocks have also been performing well in the last three weeks. Bank of America (NYSE:BAC) has been one of the best performers in the sector, and I believe the rally will continue at least in the short term. Long-term prospects are looking increasingly brighter as the new government is expected to take steps to stimulate growth.
First of all, let me explain the regulatory environment. Banks are subject to some of the tightest controls as they are mainly the engines of growth in an economy. If the financial system fails, almost all the related industries fail. This means that the central bank has to ensure that the financial system survives in the worst scenarios. However, sometimes these regulatory measures can go too far and start to have a negative impact. Hike in required liquidity reserves was one of the regulations that helped the U.S. financial system to have a stronger footing in the wake of the financial crisis of 2008. However, as the economy has grown, this requirement has remained on the higher side.
This rationale behind an increased liquidity requirement is simple and understandable. If the bank is unable to meet withdrawal requests, then it will create panic and the demand for withdrawals will increase further. Continued inability to meet withdrawal requests will make the people believe that the bank has defaulted and they cannot pay their money. The thing with the financial system is that the panic like this does not stay limited to one player. This will create fear and panic and the whole financial system will collapse. However, the downside of this measure is that being conservative ties a large amount of funds to low-yield assets. Bank of America has more than $500 billion in liquid assets and these assets are earning less than 1.5%, the rate of short-term government securities. Let's assume that the Trump government keeps its promise and eases regulatory burden on the banking sector, then Bank of America will stand to benefit heavily. The spread between the short-term rate and the lending rate is around 1.5%. A reduction in reserve liquidity requirements will free more cash for lending and the interest income will rise further.
Donald Trump will need to ease regulatory framework for the banking sector in order to meet his increased investment targets. If he plans on increasing spending on infrastructure and stimulate growth, then the banks need to have more funds available for lending. Decreasing the liquidity requirements will be the easiest way to do that.
If the regulatory measures are eased, then the banks will start to earn more even without any increase in the interest rates from the Federal Reserve. However, if the Federal Reserve increases the interest rate as it has been saying, then the income side of the banks will get double boost. Interest income and net interest margin (NIM) will go up as the spread will widen. For Bank of America, interest rate increase will yield better results than most of its peers. The bank has one of the largest loans portfolios and its total revenue is skewed heavily towards the interest income. For the third quarter, interest income was more than 58% of the total revenues. Mostly, this figure has been around 60% for the bank and if the interest rates rise then we can see this ratio move towards 65%. JPMorgan's (NYSE:JPM) interest income accounts for 56% and Wells Fargo's (NYSE:WFC) ratio is close to 59%.
In terms of valuation, Bank of America still looks a better pick than some of its peers. The table below shows the comparison between Bank of America and some of its peers.
Source: SEC Filings, Yahoo Finance, Morningstar.com, YCharts
BAC trades at a discount to its book value, indicating that the stock is still far from being overvalued despite the recent rally. Wells Fargo and JPMorgan are both trading above their book values. Citigroup (NYSE:C), however, is trading at a deeper discount than Bank of America. Taking out the impact of intangible assets, BAC's valuation goes higher. The stock is trading at a premium of about 19%. The tangible book value ratio is still lower than JPMorgan and Wells Fargo. Again, Citigroup is trading at a discount of 14% to its tangible book value per share. This type of discount in all metrics might hint towards a fundamental problem as the sentiment about the banking sector is bullish. However, I have not done any in-depth analysis about Citigroup here so I will refrain from commenting further on this stock. These ratios here are just for comparison. Based on these ratios, there is still room for Bank of America to go up.
It is true that Bank of America has had a good run and there might be a slight pullback. However, the market has not completely priced in the positives, in my opinion. Rising interest rate will increase profitability and Donald Trump's easier regulatory environment will allow for further gains. Donald Trump will need to unshackle banks in order to have increased investment. Internally, the cost cutting measures will continue to bear fruits and the profitability will also get a boost from inside. Bank's common Tier I ratio is at over 11%. Eased regulatory requirements might also result in an increase in dividend. All these factors are pointing towards a profitable 2017 for Bank of America. It is still a buy despite the recent rally.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.