Analyzing the Strength of the U.S. Banking Industry, 3Q18

Lyn Alden  |

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The previous U.S. recession was caused by a financial crisis, so it makes sense to stay on the lookout for what may trigger the next one.

While there are indeed some economic bubbles building in the U.S. economy, the banking sector is far stronger than it was during the run-up to the prior recession, meaning it's unlikely that banks and insurers would be the trigger of whatever economic misfortune befalls us next.

The following four items show where we're at in regards to bank strength.

1) 2018 Dodd-Frank Stress Tests

Each year in the summer, the Federal Reserve performs Dodd-Frank Act stress tests on major U.S. banks to estimate how well their balance sheets would react to a major recession.

Specifically, they assume a 7.5% reduction in GDP, a spike to 10% unemployment, that the housing market loses about a third of its value, and that the Dow Jones loses about two-thirds of its value.

This summer, the results were a solid success. Out of dozens of institutions tested, only one noticeably failed. That was Deutsche Bank's  (DB) American unit, which has also failed some prior tests. Goldman Sachs  (GS) and Morgan Stanley  (MS) had minor one-time accounting issues due to U.S. corporate tax cuts, and State Street  (STT) and Capital One  (COF) both had minor issues but not serious deficiencies. The rest were all given a full pass, allowing them to boost dividends and buybacks.

This chart shows the percentage of loan losses that each major bank is expected to have in such a severe recession:

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Source: 2018 Federal Reserve Stress Test Results

Banks with major credit card exposure like American Express  (AXP), Barclays US  (BCS), Capital One, and Discover  (DFS), have some of the highest projected loan losses. But most of them easily pass the stress test because they also have the largest relative reserves of capital to be able to withstand those magnitudes of losses.

Mortgage-focused banks like Wells Fargo  (WFC) are near the median, with moderate projected losses. Custodian banks like Bank of NY-Mellon and State Street have among the lowest projected losses.

Overall, the stress tests keep showing year after year that the vast majority of large U.S. banks are in sufficient shape to weather even a severe recession.

2) Household Debt to GDP

Total household debt as a percentage of GDP is noticeably lower than it was prior to the 2008 financial crisis:

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Source: IMF, charted by the Federal Reserve Bank of St. Louis

From 2005-2008, lenders were allowing subprime borrowers to over-leverage themselves on housing and other consumer debt. As a result, the percentage of household debt to GDP increased to nearly 100%.

Fortunately, there has been significant deleveraging in the years since then, and banks are more strict with lending standards and face tighter regulation. As a result, household debt as a percentage of GDP has remained flat at around 80%.

Although total absolute consumer debt is higher than it was a decade ago, the economy has grown as well, so the relative size of that debt is mildly diminished compared to assets and income.

This puts banks at much lower risk in the event of a decline in housing prices or a weakening economy.

3) Credit Card Charge-Offs

Banks continue to report low rates of credit card delinquency, at under 4%:

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Source: Federal Reserve Bank of St. Louis

In general, banks are focusing on consumers with higher credit scores, which is helping to keep credit card losses at very healthy levels. Although we're seeing a slight uptick in losses in 2017 and 2018, the numbers are still well in line with previous market expansions.

While we will certainly see a spike in credit card losses the next time we have a recession, credit card lenders have much more capital this time around to withstand those losses.

4) Equity to Assets

Due to regulations and other factors, banks have a higher ratio of equity to assets than time in recent history:

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Source: Federal Reserve Bank of St. Louis

In 1990, bank equity was about 6.5% of assets. In 2001, it was about 8.5%. In 2007, it was up to 10%, and in 2018 it is over 11%. Based on this metric, banks have a bit less leverage than they used to.

Most recessions don't result in a decline in the equity-to-assets ratio, but the 2008 recession was so severe that it did. However, banks survived and emerged from the crisis had better liquidity than before, and have kept it steady since then.

Final Thoughts

The next economic downturn, whenever it comes, will surely hammer bank stocks. However, because banks are much stronger than they were in 2007, banks are unlikely to be the cause of the next downturn and are positioned to weather it much better than they did last time.

American consumers have less leverage and banks have larger capital reserves to withstand loan losses compared to the prior crisis.

Companies in the S&P 500 currently have an average price-to-earnings ratio of over 24. The Financial Select Sector SPDR Fund (XLF) on the other hand currently has a price-to-earnings ratio of just over 13.

While lower valuations are warranted for the financial sector due to higher volatility and economic sensitivity, I do believe that there is considerable value in the sector. Banks are very well-positioned compared to a decade ago, but appear to be priced at a higher risk level than they truly are.

Long-term investors that can withstand volatility and hold through market downturns are likely to be well-rewarded by holding some of the strongest banks at current prices.

DISCLOSURE: I am long DFS and TRV.


The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.

Companies

Symbol Name Price Change % Volume
BCS Barclays PLC 8.48 0.10 1.19 4,621,209 Trade
MS Morgan Stanley 43.66 0.22 0.51 10,494,743 Trade
AXP American Express Company 116.76 -2.34 -1.96 6,195,550 Trade
DB Deutsche Bank AG 7.92 0.02 0.25 5,034,929 Trade
GS Goldman Sachs Group Inc. (The) 206.52 0.06 0.03 2,207,607 Trade
COF Capital One Financial Corporation 89.80 -0.21 -0.23 2,182,331 Trade
STT State Street Corporation 63.34 3.64 6.10 5,023,523 Trade

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