Banks

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Includes: KBE, KBWB, KIE, KRE, WFC
by: David Kotok

As clients know, we have liked and continue to like exposure to banks. We favor the big banks and have a position in the PowerShares KBW Bank Portfolio ETF (NASDAQ:KBWB), a fund that captures the big banks. We also hold the SPDR S&P Regional Banking ETF (NYSEARCA:KRE) and the SPDR S&P Insurance ETF (NYSEARCA:KIE). We are overweight the sector. We will get to why in a minute.

The quarterly earnings parade of the banks is underway. We mostly like what we see. Results being reported are not bad, and in some cases, are really good.

Among the big banks, only Wells Fargo (NYSE:WFC) is continuing to experience embarrassment over its behavior. Clawback of the compensation of former leaders is the latest headline. Here's a WSJ story on that sorry subject. The credit card sales affair and subsequent penalty has haunted the bank. Read that story here.

Among the 15 important middle-sized regional banks, only Northern Trust failed its "living will" test, according to the Fed and the FDIC. See the story here. Note that Wells Fargo was previously a "living will" casualty and endured some restrictions because of it. Read more here.

For those serious readers who want to examine the entirety of the banking system and view the size rankings of banks as well as lots of other important data, see here. A full discussion of "living wills" and how these rules are applied can be found at this website.

Here are some reasons why we think the banks are headed for an extended bull market recovery cycle.

  1. Banking sector returns on assets, returns on equity, and quarterly net income have recovered to about the pre-financial crisis level. The same is true for loss provisions, while nonperforming real estate loans have been in decline for several years. Net interest margins are in recovery. In sum, the picture of the banking sector is a lot better than it was coming out of the financial crisis.
  2. American banks have the ability to fund themselves with low-cost deposits. In a world that wants US dollar funding, American banks have this idiosyncratic advantage over other global banks.
  3. The final issue is in the arena of regulatory relief. Here, there is debate. Some relief must come through legislation, and this requires accommodation between the Trump administration and the Congress. So far, this prospect looks problematic.
  4. But other relief can come from what the Wall Street Journal calls the administration's "power to interpret and enforce financial regulations." (See the March 29 WSJ column by Aaron Back, entitled "Trump's free hand on bank deregulation.") The WSJ analysis notes how this could occur without Congress. Example: Changing the liquidity classification of Fannie Mae and Freddie Mac so that they count just as US Treasury securities do would allow banks to hold more GSE paper. Goldman estimates this change would add 2.5% to annual earnings at the largest banks and 1.8% at the regionals. Separately, this rule change would make it easier for the Fed to reduce the size of its balance sheet by allowing the market to absorb its holdings of GSE paper.
  5. Another dramatic change could occur with regulation. Currently, when calculating the coverage ratio, banks have to count their holdings in extremely safe assets like Treasury bills or reserve deposits at the Fed. If regulators were to change the calculation method to exclude these items, the impact would be huge. Keefe, Bruyette & Woods estimates that this single change could raise earnings at the big eight banks by over 13% next year (2018).

Let's sum this up. The banking system has improved, and continues to do so. Only a few banks now cause industry embarrassment. Earnings appear to be stabilizing in the post-crisis period. Regulation can give banks a large boost in earnings without Congressional action. If President Trump can obtain Congress's help, the boost may be even larger.

We like the banks. We own exposure in our separately managed ETF accounts. We disagree with those writers who forecast that "the bank party is over."

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