Rising inflation joins growing competition and digital disruption as key threats for banking in 2022.
Prominent banking analyst Tom Brown tells us why he nonetheless has a rosy outlook for the industry this year.
A few takeaways from our conversation:
Positive 2022 drivers: Higher rates that stand to widen net interest margins, and loan growth for consumers and businesses.
Inflation is at its highest in 40 years, but the bigger risk for banks if the Fed is too aggressive in trying to reverse the price trend.
The M&A frenzy will continue in 2022 as part of a consolidation in banking that still has a long way to go to reach the right size.
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Below is a full transcript of my interview with Tom Brown.
Tom, let’s just jump right in with what’s probably the question of foremost interest to our audience. What is your outlook for bank stocks in 2022 and why?
I’m incredibly bullish for 2022 and really beyond. The industry has withstood a dramatic decline in interest rates, going from in 1980, the all-time highs, to 2020, the all-time lows. And we didn’t have any loan growth and couldn’t drive earnings asset growth because interest rates were so low and banks didn’t want to buy long-term securities. The prospect that we’re seeing now, loan growth, is really a factor that means that net interest income growth will be stronger and that means earnings growth will be stronger. I think that’s the main factors behind my bullishness.
I saw a news story recently that some institutional investors are wary about adding to their bank stock positions. And that’s because of economic uncertainties created by Omicron that’s sweeping through the country. It doesn’t seem like we’re headed for another economic lockdown like we saw in 2020, so how much risk do you see in Omicron presenting to the banks?
The concern is fading, and I base that on really the experience of what happened in South Africa and the experience of what happened in London with Omicron. I see some people, we noticed from the airline traffic statistics, for instance, that there has been a little bit of a low down in travel. But I think that will be done by February, and we’re going to have a boost to the economy from sort of a mini-reopening again.
Tom, inflation is also sweeping through the country. The consumer price index for December was up 7%. That’s its highest rate in nearly four decades. In one of your recent Tom Brown’s Banking Weekly newsletters, you said you’d leave it to others to predict the impact of inflation on interest rates. But let me draw you out a little bit on that. How do you see rates responding, and what might be the impact on banks in the short term and then maybe further out as well?
Well, the current long-term Treasury rate is 1.8%, and that is totally inconsistent with history. If you believe that the long-term inflation expectations are somewhere in the 3% to 4% range today. The biggest risk to the banking industry is inflation and that the Fed responds too aggressively to that inflation risk. But right now, that’s what I’m watching. It hasn’t affected certainly our investment decisions, but the rate of inflation needs to come down. The rate of inflation related to goods will come down. My concern is inflation driven by the employment cost index rising, it’s the biggest area that we should be watching this year.
That’s a good point. I mean, the higher rates would certainly be welcome on the revenue side, given how repressed net interest margins are. The banks are dealing with that. But what about this cost side? How much is the current inflation trend affecting banks with their cost structure?
Well, it’s a good point. I think if I look at every analyst earnings expectation for 2022, I believe that their models build in too conservative a growth assumption for net interest income, but also too conservative in their growth assumptions for expenses. I think inflation will push expenses for the banking industry higher than anticipated this year, but also as part of that expense increase is a talent mix shift at the banks. There’s fewer branch-based, lower-level employees and there’s more tech talent. And that is causing some of the inflation in the staff expenses for banks.
Fed Chairman Powell has been evolving his public statements on this inflation that we’re seeing. Last fall his view was that the upswing in inflation was transitory. More recently, he said that any Fed action will be focused on not letting inflation get “entrenched,” and at the same time, he wants to avoid tanking the economy, right? How much faith do you have that the Fed has the tools and the know-how, that they have that fine aim that they need to be able to thread that needle?
Well, Terry, I’ve been concerned that the Fed has been too late to the table for about a year now. That’s why inflation is my number one concern. But there’s no question that the Fed has the right tools. The question is that those tools are very blunt and they take time to act, which is why I wanted the Fed to act sooner in terms of reducing its purchases, certainly of Treasury securities and mortgage securities in the open market. But I have confidence that the Fed has the tools – the question is, have they been too late to start to use any of them?
A lot of bankers out there, many of them in leadership roles now – for them, inflation at 7% and perhaps heading higher if the current trend continues is something that they’ve only read about or they’ve seen in other countries. Are you concerned at all that U.S. banks may not be sufficiently experienced or knowledgeable enough to respond appropriately to the impacts of higher inflation?
It’s an interesting question because, in last week’s Tom Brown’s Banking Weekly, we published a statistic that only 23% of the workforce is over the age of 55 and has some memory of when inflation was a problem. So I think your point is a real good one, which is that there’s just a lot of people that don’t know how ugly inflation can be and what the Fed has to do to root out entrenched inflation.
Tom, let’s talk about some of the other factors that make you bullish on banks in 2022. You mentioned loan growth as one of those factors. Are you seeing that growth in consumer lending or in business lending? Are you seeing in both, perhaps, and what’s driving loan demand? And are those drivers strong enough to endure in a higher-rate environment?
What we are seeing in both areas. Really in the second half of 2021, is when we saw net loan growth for the banking industry begin. If we take a look first at the consumer side, the consumer has never been in a better shape to borrow. When the recession hit in 2020, the consumer does what the consumer always does. It stops spending, it pays down debt, it saved more. And then its asset values, whether they be in stocks or bonds or in their home equity, all went up. So right now, the consumer is just in a great position to borrow. I think we will see a lot of borrowing not to buy goods necessarily, but to buy experiences. The travel that people forego in 2021 and 2020 is what I think will come back in 2022 and 2023. Businesses, on the other side, are borrowing to expand their capacity to produce goods, part of which was related to just the supply chain issues. But we’re seeing both consumer and commercial loan demand, which is a good thing.
So banks are awash in deposits right now. Their deposit base is higher than their loan base by a fair bit, so being able to remix this asset base that they have, how important is that for the banks going forward?
I call it the great asset mix shift, that’s going on. There’s a couple of parts that you mentioned. One is the excess cash that banks have on their balance sheets, particularly the largest banks. Just putting that cash to work at 1.5% rather than the 10 basis points that they are currently earning at the Fed, that would add about 5% to the net interest income of most of the large banks. But the other mix shift, which you also alluded to, was there are $7 trillion more of deposits in the banking industry than there are loans. Until 2010, the total deposits in the banking industry were about equal to the total loans. That expanded until the coronavirus hit, and then it expanded by another $4 trillion. It went from matching to a $3 trillion difference between deposits and loans to a $7 trillion difference. If we could just get back to the same loan-to-deposit ratio that we had when the coronavirus hit in March of 2020, the banking industry’s earnings would rise by 25%. This asset mix shift away from cash and into securities and, more importantly, into loans will be the driving factor behind bank earnings for the next several years.
Tom, I want to ask you about a couple of emerging areas of interest for the banking industry. The first of these is cryptocurrencies. As we’re speaking, Bitcoin and other leading cryptos, they’re down by more than a third from their highs in November, and they’re showing a relatively high correlation to the stock market, which suggests there’s a lot of speculative money moving in and out of that market. Why is it that banks now seem to be dipping their toes, maybe walking in shin-high, into crypto? Is this a FOMO situation, fear of missing out, or is it something more than that?
I think it’s something more than that. Well, I don’t own any crypto. I’m surprised at the high percentage of the U.S. population that does. But clearly, the main driver is cryptocurrency, particularly Bitcoin, is a store of value. And it’s equivalent to gold or it’s equivalent to collectibles like art or trading cards. And the value of those items are really determined by supply and demand. There’s no intrinsic value, if you will, to a Picasso. It’s canvas and some paint. But if somebody wants to spend $5 million to buy a Picasso painting, that’s what the value is. That’s how I view cryptocurrency. The customers want it, so the banks should be involved. But I certainly don’t want the banks to be investors in cryptocurrency.
I also want to get your take on buy now, pay later, which, as a payment option, is growing at a pretty rapid clip, especially among younger Americans. How are you looking at that, both in terms of the opportunities that may present for banks and also as a potential disruptor to their lucrative card businesses?
We haven’t seen it disrupt the card business yet, but I do think you’re going to continue to see rapid penetration in the U.S. from buy now, pay later. But that will only take place as long as the merchants are willing to subsidize it. And the merchants are willing to do that at very low, almost zero, interest rates. As interest rates rise, the merchants are going to subsidize it less and the banks, to keep it going, will have to take on the economic burden. And I think they will at the beginning, because of competition. And I also think they will compete in terms of terms, where they’ll extend buy now, pay later to lower credit-rated individuals. And both of those trends will probably cause a generic problem in buy now, pay later because as certain high level of rates and as certain low credit scores, there will be some economic problems caused for the banks, and then the trend will readjust.
The last thing on my list to discuss with you is M&A. So 2021 was kind of a big year for banking combinations. How do you see the M&A market in financial services playing out in 2022? Did all the deals get done last year?
Well, let’s recognize that the U.S., with its federal and state laws and regulations, we had an uneconomic banking system when you compare it to the rest of the world. In 1980, that began to change when we started to deregulate interest rates and we began to deregulate geographic restrictions. We had 18,000 banks back then. Today we have 5,000. Of the 5,000, 4,000 of them have $1 billion in assets or less. That’s tough to make an attractive return on equity, so I do think we will see consolidation at all levels continue. We typically lose about 3% to 4% of whatever banks that we started with at the beginning of the year, so I would expect that we’d see somewhere between 150 and 250 bank acquisitions and mergers this year. If bank stock prices are rising, we’ll be at the high end of that range. If bank stock prices go down, we’ll be at the low end of that range. But we’re a long way from having an economic system that’s as economical as we see in other industrialized nations.
You had some pretty tart observations in one of your recent newsletters about the proposed BMO-Bank of the West deal that was announced in December. You compared it to some deals in the 1990s that didn’t turn out too well for shareholders. In your view, does a BMO-Bank of the West deal in 2021-22 make any more sense than the deal in which current owner BNP Paribas bought Bank of the West back in the late 70s? Are there different synergies now? Is there a better fit? And who wins that deal?
Well, I think who wins that deal is BNP to get out of retail banking in a foreign country. Also, they needed the capital. But the banking business, as you know very well, is changing so rapidly that the problem with a large deal like this for BMO is that it stops you from changing because you have to focus for the next two years on consolidating what you just bought, as opposed to changing the underlying banking business. That’s the biggest negative in this deal. The 1997-98 deals, the 12 largest were terrible. The average company missed their earnings forecast by 12% in the next two years after the deals were announced. But more importantly, they missed out on changing how their company operates. That’s what I think Bank of Montreal missed in this case.
BMO says the deal is about greater scale and reach into the lucrative California market, which is the same thing U.S. Bank said a few months ago after making a similar acquisition. We’ll see how well it pans out for both of them. Tom Brown from Second Curve Capital, many thanks again for joining us on the BAI Banking Strategies podcast.
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