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Challenges and Opportunities—A Banking Industry Update

By John Loesch, CFA
May 26, 2020

(For more, please listen to our recent podcast.)

The current market environment has been challenging for bank stocks, with many trading below tangible book value amid concerns over the potential balance sheet impact of the pandemic. Banks are also contending with newly implemented accounting requirements that make quantifying potential future credit losses more difficult, in addition to a record low interest rate environment that is pressuring net interest margins. Investors should be focused on understanding the nuances of each bank’s loan book and underwriting capabilities, and applying lessons learned from the financial crisis to help make sense of the current environment for banks.

Credit Losses

While construction lending or over-leveraged single-family home buyers may have been the drivers of the previous credit cycle, this time it’s a voluntary shutdown of the entire economy in an attempt to mitigate the spread of a potentially deadly virus. Bank balance sheets could be negatively affected through loans made to hospitality or travel-related businesses such as hotels, restaurants or brick-and-mortar retail. Energy loans are another area of concern due to the dramatic decline in oil prices after Saudi Arabia and Russia failed to agree on production cuts, and the unprecedented demand drop tied to worldwide lockdowns. Spiking unemployment hindering mortgage payments could also lead to significant credit losses for banks.

That said, banks in general are in a much stronger position than they were in the previous cycle. Capital levels are higher, and banks are carrying significantly more liquidity. Banks have also made a conscious effort to de-risk their balance sheets with tighter underwriting standards, and the riskiest loans have essentially been pushed out of the commercial banking system. The Fed also moved faster and more aggressively to shore up the banking system. And we are seeing numerous programs aimed at helping borrowers with loan modifications—buying time to get to the other side. Systematically, the banking system appears in better shape to deal with rising credit costs in the future, but time will tell how much impact these issues will have on individual company balance sheets.

CECL

The current expected credit losses methodology (CECL) took effect in Q1 2020—in retrospect, perhaps the worst possible timing for an accounting change. At a very high level, under the old regime, banks would have increased provision expenses when they saw credit problems. If a commercial borrower’s financial situation was deteriorating and there was a reasonable likelihood that the bank would have a loss, the bank would make a provision for that particular loan. Under the new standard, banks looking out over a reasonable forecast period are being required to recognize expected credit losses all at once for that period.

CECL is driven by forecast models from credit rating agencies, and different banks use different forecasts and time periods to make loss assumptions. This inconsistent approach could make provision expenses significantly higher or lower depending on the bank and the forecast used, making comparability of earnings even more challenging.

Despite the lack of consistency in the application of CECL, many banks are taking significant provisioning pain upfront, unlike the last credit cycle where an elevated provision expense could drag on for several years. We believe most of the pain in this area will be felt in 2020, and there are management teams within the industry who believe that all of the provisioning pain will be felt by the end of the third quarter.

Interest Rates

Interest rates have seen a sharp move downward since the beginning of 2020. While this is a near-term headwind for banks, not all firms will be equally affected. Some banks with primarily fixed-rate loans can lower their deposit costs and increase margins. Others with zero-cost deposits and primarily variable-rate loan books will have little-to-no wiggle room and margins will be pressured. It’s important to note that banks have been actively seeking to protect their balance sheets, with many engaging in opportunistic hedges designed to protect them on the downside from declining rates while at the same time limiting or only giving up modest upside if rates increase.

Our focus now remains on understanding the normalized earnings power of our holdings and prospective holdings—digging deep to understand each company’s capital position and balance sheet, exposures, loss potential and competitive advantages. Our aim is to identify those banks that are positioned to weather expected credit losses and regulatory complexity and can see their long-term earnings power either little affected or even improved due to market share gains and improved efficiencies.

This material is for informational purposes and is prepared by Diamond Hill Capital Management. The opinions expressed are as of the date of publication and are subject to change. These opinions are not intended to be a forecast of future events, the guarantee of future results or investment advice. Reliance upon this information is in the sole discretion of the reader. Investing involves risk, including the possible loss of principal.
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