The banking sector has experienced a successful year in terms of earnings, with record-breaking results. However, bank stock prices have yet to reach their previous highs. Despite this, it is important to analyze the three key drivers that are currently influencing the industry in order to gain insight into its mid- to long-term outlook.
1. The Transition to a Higher Rate Environment
The US Federal Reserve’s rapid rate-hiking cycle has been advantageous for the banking sector. As interest rates rise, a bank’s net interest income increases, as the assets tend to reprice faster than the liabilities. However, higher interest rates also come with drawbacks. Banks that invested in long-duration securities during the era of easy money now face a decline in their prices. While the impact has been shielded by held-to-maturity accounting, these potential losses may materialize if the portfolios are unwound. This is a concern that extends across the entire sector.
Although the transition from a low or negative rate environment to a positive, but inverted yield curve has occurred quickly, banks may still be able to generate profits. Banks engage in term transformation, borrowing in the short term to lend over the long term. While financial theory suggests that an inverted yield curve could pose a challenge, in practice, banks borrow and lend at different points on the curve. Additionally, the average maturities of loans and securities tend to be below five years, and assets and liabilities are well matched. Evidence suggests that banks can even increase their net interest margin with a flat curve.
2. Reduced Competition from Neobanks
Neobanks and fintechs emerged as a result of low interest rates and technological disruption. Traditional banks faced fierce competition, as they sought alternative sources of income due to historically low spreads on their core products. This competition led to higher fees for services such as credit cards and cash transfers. However, with the end of easy financing rounds and the majority of neobanks struggling to achieve profitability, their survival is uncertain. As traditional banks refocus on interest income, the pressure to increase service fees will diminish. Neobanks may struggle to retain customers if their fees are comparable to those of traditional banks. Traditional banks may even consider reducing their commissions now that their interest income provides financial stability.
3. Market Multiples
The banking sector is currently undervalued compared to other industries. Price-to-book is the universal multiple used to evaluate banks, and many banks still have values below 1. Several factors contribute to this situation. Despite improving earnings, there are concerns on the horizon, such as the possibility of unilateral government action through direct taxes, increased regulation, and additional capital requirements. Compliance departments within banks are also growing larger, putting additional pressure on profitability. Unrealized losses on securities portfolios pose another challenge, as their potential size and impact on liquidity remain uncertain. Slower credit growth due to tighter conditions and a deteriorating economy further adds to the difficulties. However, while Germany and Holland are experiencing a technical recession, the United States has maintained a robust GDP and resilient labor market, resulting in higher price-to-book ratios for US banks compared to their European peers. Nevertheless, increasing credit card and auto loan delinquency rates and an uncertain outlook for the housing market are causes for concern as interest rates remain elevated.
Looking Forward
The banking sector is currently in a stronger position than during the last decade of low or negative rates. The decline in competition from neobanks will provide some banks with the opportunity to acquire these firms and integrate their technology stacks. However, banks must also consider the potential losses in their securities portfolios, the risks associated with increased government intervention, and the impact of higher rates on the economy. The next few quarters will present both challenges and opportunities for the sector.
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All posts reflect the author’s opinion and should not be considered investment advice. The opinions expressed do not necessarily reflect the views of CFA Institute or the author’s employer.
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