W@C – Bank earnings amid the crisis that never was : 17/04 – 21/04

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It feels like an eternity ago, but only last month we had the unwinding of one of the biggest banking disruptions in recent times. Even though, as we know, Europe got a taste of this turmoil, the origin of it was in the US and specifically in its regional banking sphere. “Crisis” was the term that was being used as the events were unfolding. But was it ever really a crisis?

Some of these very same small/medium-sized financial institutions released their first-quarter earnings reports during the week, alongside some of the biggest players. The dramatic crisis tone that had been used kind of vanished. Some people are now even saying that everything is clear. No crisis, end of the story. Another financial markets-like mood swing. If you have been accompanying the W@C, you may be starting to get used to this.

Prior to this week, there was this concern among market analysts that big banks would eat up the business of the regional banks, which would be dried out of clients’ deposits via two mechanisms: (1) a flight to quality – implying clients to move their deposits to the big banking names, getting “the safety of the name” – and (2) a general banking outflow – affecting both small and big banks – due to the attractiveness of the super-safe and now relatively high-yielding government treasuries.

The narrative around the first mechanism was one of the dominant themes since the fallouts of SVB and Signature banks. Given the current situation, in which both recession fears and funding and financing costs were and still are rising, this outcome would be natural.

Not only small banks would get absolutely hammered in the conduct of their business, but the biggest banks – JP Morgan, Citi, and their BFFs – would benefit extremely from it. Why? Just imagine the situation in which, while making the most out of the general increases in interest rates in the loans and financing they grant, the banks would see an inflow of money from new clients without raising their microscopic deposit rates not even a bit to attract them. Paradise.

This indeed showed up in their earnings. On Friday the 14^th, while most of us were enjoying the so short and well-deserved Easter holidays – including myself, that changed the Week at the Close reporting activity by a tan-getting activity in the beautiful beaches of my Portugal – the two players referred to above (JPM and Citi) reported their Q1 financial statements.

JP Morgan showed its net interest income to be up more than 40% as a consequence of this new paradigm. Bank of America, which reported this week, had a drop in their deposits in dollar terms – which may in part be explained, as stated before, by the attractiveness of parking cash in safe fixed-income securities – but faced a record number of new digital log-ins: a build-up of 130,000 new consumer checking accounts. These new clients had to come from somewhere.

Following the big names that reported last Friday, the market had a positive reaction and drove up the stocks of these banks. But something remarkable happened. Typically, in the banking sector, we were used to seeing the most important names report, the market replying in terms of price action, which then had a contagion effect on the stocks of the smaller banks. The whole sector is usually moved by the movement of the big banks. Not this time.

The regional banking sector as a whole, represented in ETFs such as the KRE, and some of these banks in specific that were connected in a more mediatic way with the March episodes, faced some stock price declines. The market was bidding up its theory of banking trouble ahead.

Data from: https://finance.yahoo.com/quote/KRE/ – Year-to-date performance of KRE.

Nonetheless, the regionals’ earnings came in a bit lighter (i.e., less negative) than some people would have thought. The trouble seems contained. But we got diverging signals, and getting a global conclusion out of this week’s reports is not straightforward. Some key points, however, are worth noting.

First and foremost, deposits. No clear sign. Some banks, especially State Street, faced higher-than-expected outflows, while some even faced unexpected inflows, like BNY Mellon. The numbers published by this latter bank bring us to a second point: net loans, which were lower than predicted.

These may seem not much related to the deposit-flight story, which is more of a short-term event, while lower net loans speak to the central bank-induced constrained credit conditions the economy is facing via the overall rate increases of the last year and a half – and will have a longer-term impact through the impact on GDP. However, the relationship between the two is more relevant than what appears.

That’s because the regional banks, unlike the big ballers, have to necessarily increase the rates they pay on checking accounts to keep the clients’ deposits within their books. The intuition is simple: why would I, as a client, put my money on smaller institutions if the benefit I get is the same that I would get if I had it parked in safer institutions?

Western Alliance’s reports highlighted exactly this: the average rate it is paying on interest-bearing accounts rose to 2.75 percent in the first quarter, up from 0.2 percent a year ago.

The consequence of this? If a bank has higher interest costs, it will need to retract from giving loans at the small rates that were the norm over the last decade or so, in order to bring up its interest income as well. Either a decrease in loan demand due to the higher rates or a decrease in the number of loans underwritten by the bank will be reflected precisely in lower net loans.

Despite all these possible troubles, the sentiment shifted to declaring the banking crisis as a battle already won. Most of these banks saw their shares rise back during the week. All clear. But by how much? For how long will we avert these problems? I am not trying futurology, but we already know something about how quickly the market changes the narrative.

If everything is indeed clear, this may have an impact on the Federal Reserve’s actions. As long as economic data, namely inflation and labor indicators, continue decelerating and start doing so in a convincing fashion, we probably won’t see another narrative shift in this aspect. But if, eventually, the Fed has the need to tighten conditions further, this relaxation in the problem perception on the banking system will make the decision of central bankers easier. No need to think that much about second-order effects when communicating their decisions. And if that’s the case, through the mechanisms explained above, the small banks’ suffering may not be over.