FactSet Research: Rising Yield Curve Disrupts Traditional Bank Pecking Order

In 2019, we Noted that the fall in interest rates was a net negative for banks under existing conditions. Of course, the world is a very different place in 2021 than it was in 2019, and banks are now enjoying a much more favorable interest rate environment.

Half-yearly analysis

2-10 year Treasury spread

The spread between two-year and ten-year Treasury bills is a traditional indicator of how favorable the interest rate environment is for banks. Borrowing short and lending for the long term can be a dangerous game and banks are taking steps to align the term of their funding with their earning assets, but ultimately some of that risk is inevitable for banks. Over the past two quarters, however, a sharply widening 2 to 10 spread has offered a dramatic windfall to bank shareholders.

In the nearly six months from September 30, 2020 to March 9, 2021, the 2-10 spread has more than doubled from just 55 basis points (bps) to a much healthier level of 138 bps. Most of the 83bp spread came from the higher 10-year yield; the two-year yield actually fell 3bp while the 10-year yield increased 86bp. The result is that banks have enjoyed welcome relief from the overwhelming pressure on net interest margins.

Given that net interest income (NII) – money banks capitalize on the spread between their funding costs and returns on assets – accounts for about two-thirds of a typical bank’s total income, this has a significant impact on the earnings outlook for banks and stocks. the prices reflected this. From September 30 to March 9 – when the S&P 500 rose 15% in very good health – the KBW Nasdaq Banking Index, made up of 24 major banks, is up 62%.

The 47% outperformance in just under six months isn’t mediocre, but even that somewhat underestimates what the steeper curve does for banks.

KBW Nasdaq index of regional banks

On the other hand, the KBW Nasdaq index of regional banks, which includes 50 mid-sized banks, nearly doubled over the same period, up 95%, outperforming the S&P 500 by 79%. If we find ourselves having dinner with the manager of a portfolio of shares in a regional bank, let him withdraw the check; he will know why.

Analysis over one year

We live in a multi-factor world, which makes the tandem evolution of the 2-10 Spread and the KBW Nasdaq Regional Bank Index over the past year truly remarkable. As the graph below shows, the only real gap is in the first few weeks of the period; it is up to the reader to discern why bank stocks were able to trade contrary to this model during the second half of March 2020.

There are many differences between the constituents of each index, but the key to the performance differential here is expense income, or more specifically, the lack of it. At first glance, this is counterintuitive; Commission income is generally highly prized in banks, and those with more commissions traditionally trade at multiples of much higher tangible earnings and book value.

Valuations of commission income are not universal

One problem with this trite (and normally correct) view is that not all fee income has the same value. Asset management generates commission income that can greatly benefit a bank’s valuation, but it’s a business that requires scale. Insurance brokerage generates commission income for some banks, but companies listed on bank-owned brokers generally do not trade at a high premium for banks (although commission income is still used to reduce reliance on spread loans and may be countercyclical during weak points in the credit and interest rate cycle).

Mortgage issuance is another common source of commission income for banks and not only does it tend to get a low valuation, but the short-term outlook for the company varies inversely with the Treasury yield at 10. year ; the 86bp increase in the 10-year rate is pure bad news for refinancing volumes. Historically, banks have also serviced mortgages, which was a natural hedge as lower refinancing volumes also mean fewer insured loans will be prepaid, but since the service business is so scalable it s is consolidated and far fewer banks are now benefiting from it. income stream.

The real problem with the thesis that more fees are better at this point, however, is that there is simply nothing the banks do that benefits so much from the significantly steeper yield curve than lending to the bank. ‘Ancient. The difference between the combinations of activities that depend largely on net interest income and those that are diversified among interest and commission generating activities explains the difference between the indices.

Total income in 2020 from net income and other than interest

Among the large-cap banks in the KBW Nasdaq Banking Index are giants that are not particularly dependent on traditional lending. State Street trust / processing banks, Bank of New York Mellon, and Northern Trust together make up 10% of the index and, on average, net interest income was only 20% of their total income in 2020. The four large universal banks – JPMorgan Chase, Wells Fargo, Bank of America and Citigroup together account for 32% of the index, and net interest income averaged 53% of their 2020 income. The index derived 58% of total 2020 income from net interest income and 42% from non-interest income.

On the other hand, the 50 banks in the KBW Nasdaq index of regional banks earned an average of 79% of total income from net interest income and only 21% – half the level of the other index – from income. other than interest. Even within this group, one can observe a certain dispersion of performances according to the net dependence on interest income. The 25 banks with the highest share of net interest income saw their shares increase by 101% on average, while shareholders of the bottom 25 enjoyed an average gain of “only” 92%. The top four quintiles all recorded average earnings ranging from 98% to 108%, but the lowest quintile, made up of banks with net interest income to total income ratios of less than 70%, generated a relatively high return. a modest 78%. In other words, with a significantly higher share of non-interest income, their performance was more comparable to that of the larger and lagging index banks.

Conclusion

On average and over time, it is surely preferable for banks to be less dependent on credit spreads and the vagaries of the yield curve. Anyone old enough to remember the savings and credit crisis will not need to be convinced. Yet recent comments from the Federal Reserve suggesting a desire both to keep short rates lower and to see inflation a little higher, mean that this trend may continue. For traditional, undiversified lenders, things can get even better, before they get (inevitably) worse.

Warning

FactSet Research Systems Inc. published this content on March 22, 2021 and is solely responsible for the information it contains. Distributed by Public, unedited and unmodified, on 22 Mar 2021 03:10:01 PM UTC.

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