An aggressively rising interest rate environment can cut both ways for the banking industry.
Tom Brown, long-time banking industry analyst and editor of Tom Brown’s Banking Weekly newsletter, offers his views on rate impacts as part of his outlook for banks in 2023 and beyond
A few takeaways from the conversation:
He believes 2023 will be a strong year for publicly traded banks, the start of a bullish decade for the sector driven by interest rates off the recent rock bottom.
In his many conversations with bank CEOs, the most common worries they express revolve around the economy, including the growing likelihood of recession.
He expects deposit betas to rise sharply in the first half of this year, while loan growth will remain strong and charge-offs will continue at very low levels.
Tom Brown, head of Second Curve Capital and editor of Tom Brown’s Banking Weekly newsletter, welcome to the BAI Banking Strategies podcast.
Thank you, Terry. It’s always a pleasure to be with you.
Let’s jump right into it. As you look out deeper into 2023, if you had to narrow it down to a single biggest issue or single biggest challenge for banks as we move deeper into the new year, what would that biggest thing be?
The fastest increase in the Fed fund’s rate since the 1980s. Question is, when is the Fed going to feel sufficiently comfortable that inflation is trending down enough that it can stop raising interest rates? And it’s a different question because the Fed wants to get inflation at 2%, but I’m thinking, and I think most people are thinking that the Fed will at some point get comfortable at the trajectory down from 8%, that we are headed toward 2% and we don’t need further increases in rates.
As we all know, its December meeting, its last meeting, the Fed did dial back its aggressiveness a bit when it comes to rates only imposing a 50 basis point hike instead of the 75 basis points that it had done in the previous four meetings. So there’s that. They’re clearly not done, but they do seem to feel like their tough love is having some impact out there, otherwise they would not have dialed it back. In light of your answer to the previous question, how do you think banking institutions should be looking at the Fed doing only 50 instead of 75 at the last meeting? And also Jay Powell’s comments about more tightening until they see that clear path to 2%.
There are some people, so the market is now split between people who expect 25 basis point increases in the Fed funds rate over the next three meetings, and those that still expect 50 at the next meeting and then 25 after that. So the bottom line is where we’re going to end up? Are we going to end up with a terminal rate that’s 5% or are we going to end up with a terminal rate of 6%? That makes a big difference to bank borrowers.
What had been worries, Tom, about a possible recession seems to have given way to an acceptance that we will have a recession and that the big question now is how severe and how long lasting that downturn will be. The Fed keeps alluding to seeking a soft landing, but do you think they can pull that off? And if so, what will it take to do that?
I think that’s going to be tough to determine. The question is what’s a recession these days? We used to say it was the two consecutive quarters of negative GDP growth, but there’s no question that the rate of economic activity is slowing. And if that means going to be negative for two or three quarters, I think that’s quite possible. But we don’t have any of the imbalances in the economy today that we’ve seen in prior recessions like in 2008 or 1989 or 2000, for instance. So I don’t think it’s going to be a hard landing if it’s technically a recession and I think it will be a softer than normal landing.
Of course, higher interest rates mean top line growth for banks and credit unions, which is not such a bad thing. And the institutions have been slow to increase deposit rates, so they’ve been enjoying those wider spreads. Is there any reason to think that the higher rate regime has been anything but a positive for the industry so far?
Well, not all banks benefit from higher interest rates. I’d say about 90% of them do. But we have institutions such as New York Community Bank, Ally, Live Oak Bank that where their deposit base is as sensitive or more sensitive to higher interest rates than their loan yields. But for the vast majority of banks, I think the net interest margins won’t peak until the Fed stops raising the Fed funds rate.
For that fairly small number of institutions, that 10% you were talking about that haven’t fared as well in this rising rate environment, do they fit a particular profile regarding size or geography or business focus or some other distinguishing feature? And given that rates are almost certainly going higher still from here, will the problem become even more pronounced for them as rates rise further?
The banks that don’t benefit are the ones that don’t have the legacy branch-based deposit network. They don’t get hurt by higher interest rates – they get hurt by the movement to higher interest rates. And so whenever we get to the point interest rates have stabilized, their asset yields will begin to catch up and it will be a better relative environment for them than it is for the banks that have a large branch based deposit base.
So Tom, in your day job, you have a lot of conversations with bank CEOs and that’s from the biggest money centers right on down. What have you been able to ascertain about what’s on their mind these days, be it to the upside or be it focused on the downside?
I do talk to about two CEOs every week, and I would say there are two real big disconnects in their mind. The first one is the current economy and the strengths of their current customer base relative to all the discussion that we have about the future economy and the potential for a recession. So they see what’s going on with their clients today, and that’s different from what they’re all worried about will happen in the future. And the second disconnect that they all talk about, of course, is the absolute and the relative valuations of their stocks, which are trading at multiples that even I think are ridiculous.
We’ll get to the stocks here in a second. But before that, I wanted to ask you about something that I read in one of your recent Tom Brown’s Banking Weekly newsletters where you recap the conversation with Jamie Dimon from JPMorgan Chase. And among the things you highlighted was a speech he made to other bank CEOs in which he told them that they do noble work and that they should be proud of what they do. So what I’m wondering is why do you suppose he felt the need to make that point to people who are at the top of their respective org charts?
I think Jamie Dimon believes that his fellow bankers don’t speak out enough to their elected representatives in Washington and that they need to make their representatives know the good things that banks do for their consumers, for their commercial borrowers, for their communities, and for the government agencies that they help all operate and do things that they want to do. I think he’s always believed that banking is a noble business, but I think what he is doing is he really wants a call to action to have these fellow bankers express that in Washington because Jamie Dimon feels that there are too many people in Washington who view bankers as the bad guys.
Now about the stocks business here, I’ve read some bullish, even extremely bullish outlooks for publicly traded banks in 2023. It would be hard to top the very upbeat views recently from Mike Mayo at Wells Fargo. He says, “A mild recession could put banks on track for their best year since the mid-’90s.” So if we put him at one end of the outlook spectrum and the most sour, pessimistic banking analyst at the other end, which one do you fall closer to and why?
Well, I’ve known Mike Mayo for 30 years, and it’s very seldom that my position would be aligned with his, but that would certainly be the case here. In fact, I would make the argument that in 2023 we could, and I believe that we will likely, begin what’s going to be a great decade for bank stocks. And that decade is going to be driven by two things. One is we’ll have gotten rid of the zero interest rate environment. So net interest margins and net interest income growth will be more favorable over the next 10 years than it has been over the last 20. The second reason is these valuations and the absolute and the relative valuations I could easily see going up by 50% on average for the group. So I think earnings and valuations will improve and that will give us a great decade for bank stocks.
I think that 50% number was the exact same number that he used in his outlook as well. But Tom, we’ve been pretty focused on interest rates for most of this conversation, but there are so many other things to talk about as well, probably more than we can get to in the limited amount of time we have left. But let me start with the value of scale in banking. The undeniable trend is that we’ve seen in recent years and especially since the pandemic started, is that the bigger are getting bigger at the expense of the smaller. So should we expect that trend to continue at the same pace or perhaps even accelerate?
Well, let’s see, in 1980 when I started covering banks, there were 18,000 FDIC-insured banks, and today there’s 4,700. I don’t see any conditions that would reverse that trend. However, scale is not one of the reasons. I began studying scale and how it relates to size back in the ’90s, and we’ve never found a correlation between asset size and efficiency in the banking industry. But every CEO I talk to wants to be twice their current size. If they’re a billion, they want to be two. If they’re five, they want to be 10. If they’re 10, they want to be 20. And if they can just get double their size, they’ll become so much more efficient. And that just doesn’t happen. Complexity of running an organization that’s twice as big as what you were running before overwhelms the economies of processing scale. So I do think we will continue to march to a lower number. We lose about 4% of the banks every year, and I don’t see that trend stopping.
Tom, I’m going to stop doing so much talking so that we can hear more from you in the time that we have left. I’ll fire some quicker questions at you, starting with deposit yields. So as we discussed earlier, banks haven’t really shared too much of the interest rate increase so far. Does that change in 2023?
Yes. The deposit betas were remarkably low through the first three quarters of 2022. They went up meaningfully in the fourth quarter, and they will go up even more in the first half of 2023. But what’s different about this cycle is how they vary between institutions. In many of the last cycles, the largest banks have been desperate for deposits and they were the price leaders on the way up. And that’s not the case this time, so the price leaders are more of the online banks than the largest branch base banks.
With all the pandemic stimulus deposits, as we were just talking about, deposit levels have soared at banks. They’ve come down from their peaks, but will a surplus continue in 2023?
Deposits will continue to decline in 2023, in my opinion. And that’s as the money supply, M2, also continues to decline as the excess funds that consumers have continue to be spent. And then as corporations redeploy the excess funds that they have as well, either to keep their operations going or to make investments in expansion.
Loan growth has been strong, but as we’ve been talking about recession, how do you see that side of the balance sheet faring in 2023?
I think we’ll look back on the peak of loan growth was the third quarter of 2022, and it will still stay, I would say, strong through the first half of 2023. However, the first quarter of 2023 is seasonally a weak quarter for loan demand, so we have to be cognizant of that.
Credit quality typically takes a hit during economic downturns. As of now, non-performing asset levels are still very low. Are banks ready if this trend changes?
Terry, as you know, the FDIC was created in 1934. In the second and third quarters of 2022, the net charge-off ratio at all the FDIC-insured banks was the lowest it’s ever been, so we all are expecting credit to normalize. But what does that mean? Does it mean the 26 basis points of charge-offs that the industry has been running is going to go to 46 basis points? I don’t think so, but it’s certainly going to go higher than the 26 that we enjoyed in 2022.
We’re already seeing layoffs and cost cutting in anticipation of tougher times ahead, which runs counter to the optimistic outlook that many have on Wall Street. Where’s the disconnect there? And how much cutting do you see in 2023?
Not that there’s such a disconnect because certain lines of business have been weak. So, for instance, there have already been large staff reductions in the mortgage banking business as a result of the increase in mortgage rates. We also have seen the trading business begin to slow down. And then of course, the investment banking business, the IPO market in 2022 was down sharply from 2021. So in certain lines of business that are cyclical, you’re seeing staff reductions. But if you were in the commercial banking business, if you’re a commercial lender, and particularly I think in 2023, if you have workout experience, there’s going to be more demand for your services.
Are there any big regulatory issues that banks are particularly concerned about here in the, say, the first half of 2023?
I think one issue in particular that I talked with Jamie Dimon about, which is reforming of Zelle, the person-to-person payments that about 1,800 banks offer to have their clients can either make payments or receive payments over the Zelle network, but not all 1,800 have invested as much in fraud detection technology, as the largest banks have. So some of the smaller banks are going to have to make some adjustments to their Zelle payment network; otherwise, the regulators or legislators come in and make the changes. And the other one that worries me for 2023 is just the CFPB and where they may head, because when they start using phrases like “junk bank fees” and they want to attack those, that worries me.
Tom, one last question, and this one is the quickest one of all. Crypto?
Crypto’s always to me been like art. I am not a big art fan. I don’t invest in art and I didn’t invest in crypto. But what’s related to crypto that is very important is the blockchain. And so the blockchain stays, and I don’t know what happens to crypto, but it is irrelevant.
This conversation’s been great as usual, Tom, but alas, it’s time to wrap it all up. You’re deeply immersed in this industry, always reading, watching, talking to people, analyzing, trying to make sense of all the things you’re taking in. At the beginning of our chat, we talked about the ongoing rate hikes as the industry’s biggest issue. Take us into the theme music by telling us what you’re most excited about or most optimistic about for banks in 2023.
I am most excited about the improvement in the management of this industry over the last 20 years, and the management has better tools in which to manage. So no matter what the economic environment throws at them in 2023, I think they’re in the best position ever to handle an economic slowdown/recession.
So Tom Brown, head of Second Curve Capital and editor of Tom Brown’s Banking Weekly newsletter, many thanks again for being with us on the BAI Banking Strategies podcast.
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