Episode Summary:
In this special episode (Episode 80), we host former hedge fund manager Marc Rubinstein to discuss the key takeaways from Banks' Q3 22 earnings calls. Marc is the author of Net Interest and writes for Bloomberg Opinion. He covers financial sector themes. We are also joined by Brian Gilmartin, CFA from Trinity Asset Management who writes the blog Fundamentalis.
Show Notes
00:00:00: Introduction
00:06:06: High-level overview of the banking industry
00:11:13: Impact of changing interest rates on net interest margins
00:16:16: Reserving Dynamics
00:18:19: Outlook for Non-performing Assets
00:32:23:Performance of Major Investment Banks on the Capital markets
00:34:33: Impact of Technology on the Banking Sector
Transcript
[00:00:00] Mokaya: Thank you and welcome to the Transcript Spaces this Wednesday evening after markets closed. Scott and I run a weekly newsletter called The Transcript where we highlight key quotes that we took away from earnings calls. And this past week it's been the start of the earnings season and the big banks at least have reported their earnings. We started as a tradition hosting Marc and Scott and someone else may join just to discuss what our key takeaways are from the banks’ Q3 earnings because that sets the pace for the rest of the Q3 earnings. I'll invite Scott to say something and then Marc can introduce himself and then we can get started. Scott.
[00:00:37] Scott: Yeah, thanks everyone for joining us for this Twitter Spaces to go through the banks’ Q3 earnings here. The beginning of the earnings season starts with financials, so we get a good look into the economy. What I've been seeing is that the consumer still seems pretty strong and credit quality is also very strong. Not a lot of changes to credit quality but there's concern over capital markets and everything else that's going on in the economy. Marc, do you want to introduce yourself and talk a little bit as well?
[00:01:07] Marc: Yeah. Thanks, Scott. Hi everyone. My name's Marc Rubinstein. I write a weekly newsletter called Net Interest, which focuses on the banks and financial services industry broadly. It's called Net Interest, a very topical title because net interest income has been a big theme. Net interest margin has been a big theme coming out of these results. We got to talk about that. Just a bit of background, I spent 10 years before launching the newsletter, managing a fund, and investing in banks and financial institutions. Before that, I was a sell-side analyst.
[00:01:46] Mokaya: All right. I think that's a good place to start. Marc, you are based in the UK, maybe you can start there and tell us what's happening in the UK in terms of the financial markets.
[00:01:54] Marc: Yeah, that's also a topical question Erick, because it looks like the Prime Minister may go tonight certainly by tomorrow. It's happening very quickly right now. The UK's been at the epicenter of a global… I wouldn't go so far as to call it a financial crisis, but certainly, a major wobble in government bond markets has occurred in the UK and that's been going on for a month or so now. Yields have recovered, they're pretty nearly back to what they were before the wobble commenced at the end of September. But in the current kind of administration, the Prime Minister hasn't got that many more days, and things are happening as we speak which makes it look like maybe there are 24 hours left for her.
[00:02:45] Scott: Marc, who's expected to take over if she steps down?
[00:02:48] Marc: That's a good question. I think if there was a clear alternative candidate then she wouldn't have survived even these past two weeks. That is the problem. Rishi Sunak who is a former hedge fund manager as it happens worked at Children's Investment and worked at Theleme as well. I shared an office with him as that happens. He came second. It could be him, but then it could be the current finance minister. The current Chancellor of the Exchequer Jeremy Hunt is pulling the strings right now anyway. It's not clear. As I say, if it was, it would've happened two weeks ago.
[00:03:22] Scott: And do you think there's any further risk to the currency here?
[00:03:25] Marc: I don’t know. I don't have insights. We hit 1.03. We got very close to parity. It didn't persist throughout the course of the trading day. That was Asian trading hours in the immediate aftermath of this kind of mini-budget which sparked off this crisis. Probably looks cheap at that level, the pound. But, for now anyway, tactically, I think the lows are in, but anything could happen. And certainly, there was an inflation print this morning over 10% which isn't particularly encouraging.
[00:03:57] Scott: And Marc, from a bank coverage standpoint, what types of banks are you typically looking at? Are you looking at the large-cap capital markets banks or more commercial banking side? International? US banks? What's your area of focus?
[00:04:10] Marc: Yeah, I look at them all. I look at US banks, I look at European banks, and I look at banks in emerging markets as well. One of the themes over the past five years, 10 years even has been a kind of convergence. There used to be banks that offered restructuring potential, banks that offered growth potential, and banks that offered various different factors. But there's been a convergence as a result of a global interest rate environment, which is now unwinding, and a regulatory regime, which has impacted all banks globally. You are not getting the growth in the banking industry that you may have gotten in emerging markets, for example, in the past anymore. And throughout the world, whether it's the US or whether it's China, frankly, very kind of extreme economic and political contexts. In spite of that, I think banks are used by authorities as a tool of policy, very explicitly in the case of China, and less explicit in the case of the US. but at the same that when dividends are required to be shut off and buybacks are required to be closed down, then it's a softer power that the Chinese authorities have but banks fundamentally act as tools of policy. And there's been a kind of convergence towards that theme as well. There was a piece that went around on Twitter recently, an interview with Russell Napier, who's a kind of macroeconomist, and he makes this point, I think without recognizing that it started in the US with Fanny & Freddie neobanks. But you've got the government influencing behavior and offering subsidized credit through financial institutions. And that's now happening all over the world. In the UK it was launched recently to help energy companies through the banks but it started in the US with the GSCs.
High-level Overview of the Banking Industry
[00:06:06] Scott: Yeah. I want to ask the highest level question on the sector before we start drilling down. I'm curious, generally speaking, there are a lot of dynamics happening for banks and bank earnings, with a potential structural change in the interest rate environment. Are you bullish or bearish in this sector? What's your general positioning relative to the industry?
[00:06:27] Marc: My view, and it follows from what I just said in the sense that there is always this kind of government overhang that impacts the sector. These are stocks to coin a phrase, “rent not own”. When we look at any company, what we're looking at fundamentally when we think about the role of management is the asset, it's the capital allocation. And banks are restricted in their ability to allocate capital because they are limited in what M&A they can do. They're limited to whether they can do buybacks. And many banks recently have turned off buybacks, and we’ll talk about why in a second. We'll drill down into this, but it's influencing the way they're managing their balance sheets accordingly. And as a result, without that liberty to allocate capital, it's difficult to own them long-term. Right now we're coming out of this kind of golden period. You mentioned right up front that we haven't seen much in the way of consumer deterioration yet, so we're in this golden period where you're not seeing the losses come through yet but you've had the benefit of higher rates. So banks have beaten earnings broadly, the ones that have reported so far. There have been some divergences, there have been some big misses, M&T, FRC, and Allied today. But broadly they've beaten this kind of golden goldilocks scenario of higher margins because of rates, but without the credit shocks yet, that's a window that's closing.
[00:08:04] Scott: And the last kind of high-level question on the sector I have is, these have traded at below market multiples for a very long time now, since the financial crisis. Do you think that's an intrinsic business model discount, or do you think there are other dynamics at play? Do you ever expect the banking industry to trade at a market multiple again?
[00:08:24] Marc: Yeah, it's an interesting question. I've thought a lot about this. The argument for why they could is that their cost of capital should now be lower given the structure of the industry is much more resilient to shock. They've got more liquidity, they've got more capital. They're not allowed to take as much risk as in prior cycles, and therefore the cost of capital should be lower. And they should consequently trade a higher multiple. I'm not sure. And certainly, empirically we can see the market will not give them the benefit of the doubt until they've navigated a recession. And we haven't had a recession since 2008. 2020 was signed and posted to have been that moment, and because of government intervention, it wasn't. If they navigate this coming recession successfully, then that could be their catalyst for a rewriting. But we've got to get through the recession first.
[00:09:24] Scott: Certainly. So where are areas that you're relatively more interested in? Are they specific lines of businesses that banks are in or geographies or what opportunities do you see?
[00:09:35] Marc: Without mentioning names, I always do look at valuation. There was a great… it's not that helpful now because I'm talking about a scenario that presented itself a couple of weeks ago but it's a good paradigm to look for. And again, it follows on from what I was just saying, which is that the sector is more resilient, has more liquidity and more capital than it did, and therefore we are highly unlikely to see a kind of a 2008 rerun and yet occasionally people in the market reached for that 2008 playbook. And the example I'm referring to was Credit Suisse a couple of weeks ago where Twitter kind of got very excited over the weekend that Credit Suisse was in trouble. And it was the 2008 playbook, the CDSs are gaping out, and the stock price is falling, but there's a firewall in place now that prevents that from being self-reinforcing.
That kind of reflexivity that used to occur where stock prices were down, clients would panic, and business would get impaired that's broken now. And so I think valuation is important. Although they trade, as we've just discussed, at a discount to market multiples, there is also a flaw that maybe wasn't there before because that reflexivity isn't there and Credit Suisse demonstrated that a couple of weeks ago. So I'm very valuation-focused. Elsewhere, there are lots of interesting things going on around the world in payments, for example. But ultimately banks are a function of two drivers and the face of those drivers is playing out in US earnings right now, and that's margins against credit. And everything else is a bit of a recession.
Impact of Changing Interest rates on Net Interest Margins
[00:11:13] Scott: Yeah. How do you expect the changing interest rate environment to affect net interest margins and profitability for a traditional commercial lender?
[00:11:23] Marc: It's an interesting question. So structurally the sector should benefit from rising rates, but like anything, in markets, we've seen something similar in the UK over the past month. There's good volatility and there's bad volatility. And the best scenario is slowly rising rates, not rapidly rising rates, and without the kind of volatility that we've seen in the UK. And the reason is very simple. Banks particularly during the pandemic took in a lot of deposits and became very flush with liquidity, therefore did not have the competitive requirement to remunerate those deposits. And so when rates went up, they got the benefit of that on the assets out of their balance sheet through high yields on their assets, be it lending assets or securities holdings without having to pay commensurately on the deposit side.
And so that gap between the yield they get on their assets and the cost of their deposits group is one of the reasons why banks have struggled up until recently. And again, coming back to this point about the discount to the market multiple, is they've arguably been underearning and they've been underearning because of a low-interest rate world, a zero-interest rate world. It was difficult for them to remunerate it to less than zero. There was that zero lower bound. US banks didn't, and some of them did. Some of the trust banks turned around to their big corporate clients and imposed fees on holding liquidity. European banks certainly did it although not to the extent that they wanted to. Swiss banks did it, turned around to clients, and started charging to hold deposits. But it's difficult and it's messy.
And so that lower bound put a floor under net interest margins. And now that's being unwound and we're seeing rapidly rising interest margins now. The one variable that analysts look at, they talk about deposit beta. And that's simply a measure of, for every hundred basis points in the Fed hikes, how many basis points other banks pass onto their customers, to their depositors. And up until recently, it had been between 10 and 20 basis points, so a beta of between 10 and 20% is better than previous hiking cycles. And two reasons for that. One is that there was so much more liquidity going into this tightening cycle because of the pandemic and the liquidity injections that happened then.
And secondly because of how quickly rates were going up. There's an inertia that consumers suffer from and rates were going up more quickly than they could comprehend. And banks were able to get away with the benefit of that. That's now changing. So I think one of the themes coming out of these results is that firstly, deposits are now starting to go into decline. So having won trillions of dollars of deposits since March 2020 deposits are now going backward. Consumers are either reallocating or they are drawing down on their deposits. This came up on a number of the earnings calls, starting to draw down on their deposits to maintain their spending patterns so deposits are going down.
And one thing we've got more of now than we had in previous tightening cycles, not 2016 one, but before that is more fintech, more online banks who are competing using price to compete for deposits. And so with deposits going backward, a bit more competition now loan growth is going up. The Fed gives weekly data and they give it every Friday. And as of Friday, and this is data for September, deposits are now declining for the industry by 9% on an annualized basis, but loans are going up 9% on an annualized basis. And so there's more of a need for funding. And this environment of being able to get away without paying for deposits is starting to go backward now. It varies by bank, but some banks warned on net interest income for next year, either explicitly or implicitly. JP Morgan, for example, said, don't annualize the Q4 net interest income into 2023. Others have warned like FRC and T and I think we're at a turning point from now on. Certainly, the rate at which the margin can get from here is now going down.
[00:16:08] Scott: Interesting. And do you know what the industry net interest margin is? What’s the average net interest margin?
[00:16:13] Marc: I don't know what the number is off the top of my head. Yeah.
Reserving Dynamics
[00:16:16] Scott: I wanted to talk about reserving dynamics as well. We've seen some of the banks start to increase their loan loss reserves. Do you see any reason to believe that they are either over or under-reserving at this point?
[00:16:28] Marc: So this is another interesting point, which is different from the previous cycle. New accounting standards came in 2020, which didn't exist in prior cycles, which require banks upfront at the point at which they write the loan to make an estimate of loan losses based on their feel for the economic outlook and to update that estimate on a quarterly basis as that feel for the economic outlook changes. And it came in at the beginning of 2020. It's called CCLC. And so what they have to do is they have to front-load all of the expectations for economic decline. Now some bankers have been very critical of it. Jamie Dimon of JP Morgan has been very critical of it. He said what they do is they do a weighted average. They disclose their underlying assumptions.
They'll take a view on unemployment, they'll take a view on rates, and they may attach 10% to an adverse recessionary scenario, 40% to a base case, 40% to a good case, and they can tweak those percentages. A couple of quarters ago, Jamie Dimon hiked up his percentage for the adverse case, and then on his call last Friday, he was asked, if he has changed his view. And he said it's the same as it was three months ago. So although he is been out in the press talking about a hurricane and talking about recessionary clouds, he still sticks to the important view because it feeds into the numbers the bank produces, and still sticks to the estimates he outlined three months ago. So the concept of under-reserving, and over-reserving, they reserve upfront for an economic outlook that they provide full transparency on. So they reserve appropriately on that basis. But then things change and there's a lot of uncertainty right now.
Outlook for Non-performing Assets
[00:18:29] Scott: . Yeah. I guess that falls into the category of unknowable by anybody. But if I think back to the covid cycle, they were heavily reserving early on in the pandemic. And then with all the stimulus came in, we had this huge economic surprise, I think to everybody that we didn't have a severe recession, or we did have a severe but extremely sharply severe recession. And so I think the banks had over-reserved. That was something I think we did pick up on, on The Transcript, that they were over-reserving at that time. But at this point, I think it is driven by what's your view of what happens to the economy, and what happens to credit quality. And so maybe that's the second part of this question do we stay in a low loan law or a low non-performing asset environment for the foreseeable future? Underwriting standards got a lot more stringent post the financial crisis, but these are low numbers. We haven't had a true recession since the financial crisis. What's your outlook for non-performing assets as you go into a more potentially traditional recession here?
[00:19:28] Marc: Yeah, and it might be a different sort of recession because maybe we're not going to get an increase in unemployment, so maybe consumers might be better behaved. Consumer credit might be better behaved than it was in certainly the prior recession in '08/09. But, the flip side is, we're already seeing, for example, losses in leverage lending on the commercial side. So the flip side is where there are assets. And in some countries, the inability to refinance on mortgages is an issue broadly where there's an asset value, where there's collateralized lending. Which is linked to a decline in asset values rather than the ability to pay through employment, for example. That could be more at risk. I was listening to a call today from the CIO of fixed income, at BlackRock and he was suggesting that commercial real estate could be an area to look at. So it could be on that basis more of a '91 type of recession as far as the banks are concerned, rather than 2008 one, which was a consumer one and real estate, or a 2001, 2002 recession, which was corporate lending. Could be very different.
[00:20:42] Scott: Yeah, I think that's a good point. Commercial real estate is something that was heavily impacted by the pandemic and you still see companies having more work from home, and people coming into the office less frequently. This was an area that was overbuilt in retail and everything. I don't know if you want to go into specific names. We don't have to if you don't want to but are there specific names that are highly levered to commercial real estate or you would be concerned about? And the flip side, are there other portfolios, loan portfolios that look particularly good in the current environment?
[00:21:14] Marc: Yeah, I haven't drilled down into particular names yet. The other thing I'm looking at very closely is delinquencies. Monthly trust, all of the credit card trusts, and any securitization vehicle will put out a monthly performance report and that’s data we can track. So we should be able to get early-stage delinquencies data and some insight on that as we've always done. That's something to look at and so far that's looking okay as well, which coming back to your point explains why the banks didn't put up more reserves for their credit card portfolios, which are very sensitive to that. So no names particularly just something to look out for there.
[00:21:52] Scott: Sure. Yeah, certainly for people listening to those. Banks have different concentrations of loan portfolios, so if you're bearish on a specific part of it, this was something we saw in 2008 in the most extreme case, people with overleverage to subprime or land or things like that, those were the banks that were most at risk.
[00:22:12] Marc: Loans are the biggest asset on a bank's balance sheet. But the second biggest asset on their balance sheet is securities and bonds. And because of the massive influx of deposit funding broadly over the period between March 2020 and let's say the end of 2021 without commensurate loan demand, they put a lot more into bonds at prices that don't look that clever. They're not traders, they're not investors in the way that we would think of bond investors, but they're sitting on a lot of underwater bonds now. And I was looking at the data, the FDIC publishes data for quarterly data for the entire banking industry in the US, and for the end of June, the end of the second quarter, haven't seen yet the end of the third quarter, the record losses on bank bond portfolios, 250 billion of aggregate losses on bond portfolios bigger than in 2008.
Firstly because treasuries anyway are down now, as they weren't then. Secondly, the bond portfolios themselves are much bigger than they were back then. So you've got big mark-to-market losses sitting on these banks’ balance sheets and now banks will say it doesn't matter because we're going to hold this stuff to maturity. In some cases, it is leading to an erosion of book value. In other cases, it's not because of the way they've chosen to account for this stuff. But that's a pretty big number, you saw 250 billion in losses in your loan book you take right now. It's a mark-to-market risk. You could say it's not credit risk because it's not all government bonds.
There's other stuff in there as well. But this comes back to this point about funding, the problem is that if deposits continue to go backward and loan growth goes up banks may have to start selling some of those securities to fund the loan growth. And there's a bit of a margin pickup because the securities are yielding. If you bought security today you'd get 4% but the stuff they were buying in 2021, they're getting 1.8% on average, maybe at 2%. And a loan would give you maybe 4 and a half percent, so there's a slight pickup. But if you were to sell, you'd be crystallizing that loss. So it's an issue that I haven't seen that much in the press but it is quite a big issue. And as I say, it's a big number.
[00:24:41] Scott: It's a very important point that you bring up. And I'm curious, as you said, the banks will say that they're going to hold these to maturity, the regulators are supposed to say that these are non-risk-bearing assets, right? So you don't have to hold capital against them. The accounting though now even in these securities portfolios, does impact the book value of the equity, is that right?
[00:25:02] Marc: So banks have a choice. They can book securities as held to maturity assets, or they can book them as available for sale. If they're held to maturity, they're not allowed to sell them until they mature. If they sell even one bond out of a portfolio, it can infect the entire portfolio, and the whole thing then has to be written down because the advantage is that if you hold it in that portfolio, you do not have to market. It sits there at amortized cost. Available for sale are mark-to-market, so available-for-sale flows through and hits the capital of the bank, held to maturity doesn't, and because of that, what banks have been doing is they've been moving securities from available for sale into held to maturity.
And so held to maturity is ballooned. It used to be a fraction of the overall portfolio, but now it's the largest part of the overall portfolio. The reason why it was a fraction is that banks preferred flexibility. Okay, we have to market it, mark-to-market but we like the flexibility of being able to sell to reinvest in high yielding, to reinvest in loans if we need it whereas held-to-maturity is not liquid. And so you've seen this massive shift towards held-to-maturity, which kind of makes these balance sheets a bit more sclerotic, a bit less easy to move, a bit less liquid than maybe banks would like. It's a choice they have but it is an issue.
[00:26:30] Scott: Yeah. And you've been talking about the deposit decline a lot as well today. That's an important dynamic that's going on. Is there a potential dynamic that just to fund the deposit outflow banks will have to take their securities portfolios down?
[00:26:46] Marc: Yeah, exactly. The one ratio analysts look at all over the world is the loan-to-deposit ratio. Ideally, it would be certainly less than a hundred percent. So you'd have more deposits than loans to give you a bit of headroom because deposits provide the funding for the loans. And you'd want a bit of headroom to grow loans to meet demand if it was there. Banks will typically run less than a hundred percent. JP Morgan reported last week, is at 45%. It's a record-low loans-to-deposit ratio. For almost $2 of deposits, they've got $1 of loans, and the rest was in cash and securities. For other banks, it's higher than that kind of 60, 70%. But if you add in this whole held-to-maturity bucket of securities, which the duration on that stuff can be five years, it can be similar to a loan, they're stuck with it, then you're getting closer to 90% in a lot of cases. A hundred percent in a lot of cases.
And one of the reasons why FRC in San Francisco, which reported last week, the stock was down 20% on the day they announced, last Friday. They're seeing loan growth. They've already got one of the highest loan deposit ratios. If you throw in their held-to-maturity pool as well, they're over a hundred percent loan to deposit. So to fund that extra loan growth, they've got to win new deposits, which means paying up for them. So the deposit costs are going up, and they can't sell those held-to-maturity securities. They've got a challenge with funding. It's not a liquidity challenge, it's a pricing challenge. They're just going to have to pay up for that funding.
[00:28:29] Scott: Is it well established as well that from a systemic standpoint, from a banking system-wide standpoint that the quantity of deposits is driven by the dynamics of QE versus QT and so as the Fed is pulling liquidity out of the system, it's a certainty that deposits will come down, is it not?
[00:28:48] Marc: Yes.
[00:28:48] Scott: So it's an interesting dynamic that banks are being saddled with potential losses, especially if you have a further increase in interest rate environment just based on durations that they're holding and everything. Very interesting. I'm curious, do you think that this is an investible thesis, I guess from the short side, not necessarily from the long side, but a kind of destruction of the book value of banks?
[00:29:11] Marc: Yeah. If you take a mark-to-market approach, there's always this debate. It is a philosophical debate in accounting and in banking between mark-to-market and held to maturity. And it came during the financial crisis. I remember vividly AIG, for example, saying that they were intent on holding some of their exposures to maturity and therefore they weren't real losses and they shouldn't be forced to write down and therefore raise capital against those exposures. Fannie and Freddie's said the same thing as well. And to be fair to them, the realized losses weren't as bad as the losses that they were discounting and being forced to reserve for back in 2008, and 2009. So it's a philosophical issue and it matters at the extreme. Now, it would matter if these banks didn't have enough capital. They do have enough capital but that could change in another leg down in bond prices. It's the point at which they become four sellers, it becomes an issue. And we're not quite there yet, but one of the things again, we've seen in the UK recently is that these things often operate on a knife action 99% of the time confidence interval. We shouldn't get to that scenario, but there is a scenario in which case it might happen.
[00:30:34] Scott: Yeah, certainly. I think in the UK this is the area where it's most extreme, right? This is an area where government bonds did a week or two ago have some sort of acute selloff which materially affects bank values in the near term.
[00:30:50] Marc: That's a good point from two weeks ago because we saw the correlation between the 10-year and bank stock prices break down.
[00:30:57] Scott: Yeah, definitely.
[00:30:57] Mokaya: We have Brian from Trinity Assets, he writes a newsletter called Fundamentalist. He can add a few thoughts on bank earnings. Scott.
[00:31:05] Scott: Yeah. Brian, did you have any questions? I saw you jumped in as a speaker.
[00:31:09] Brian: Marc, all your points are great. I just wanted to add one thing. When Scott brought up credit, Jamie Dimon said on the conference call that if the unemployment rate went to 6% he'd have to add about five to 6 billion to loan loss reserves. And I haven't run the calculation in terms of earnings, what that means in terms of EPS, but that was what he threw out there, which I thought was, he quantified it for everybody as a general rule. I thought that so far the financial sector earnings have been great except until Allied today. I don't know if you folks on the call saw what happened to Allied but it's the old G M A C gm Auto Finance Corp., they had a very big mess and they added to their reserves substantially. My first thought was that the cost of a GM truck has possibly stretched that low end of the consumer market. But that's the first time I've seen so far this year a finance company or a financial that has indicated there's a credit problem in their book. Anyway, Marc, I don't know if you saw that or not, but it was a pretty big mess. So anyway, I wanted to throw that out.
[00:32:17] Scott: Thanks for that comment. Marc, did you have any comment you wanted to add?
[00:32:20] Marc: No, I didn't look too closely at those earnings today.
Performance of Major Investment Banks on the Capital markets
[00:32:23] Scott: I did want to move to the capital markets segments of the major investment banks. And it's clear that IPO markets are frozen. We read that high-yield markets are frozen. Marc, are there any comments that you would have more broadly in terms of capital markets activity going on that maybe people who aren't following the banks as closely as you are, might not see structured credit or anything like that?
[00:32:49] Marc: No, not, it's a good question. We've seen Morgan Stanley and we've seen Goldman report as well as JP Morgan and City, which are big capital markets businesses, I haven't seen anything surprising coming out of those yet. These businesses on the trading side have been doing quite well. They like volatility broadly and I talked before briefly about the concept of good volatility and bad volatility and the concept of rates. These businesses like good volatility, they like trading, and there's been a lot of trading activity over the past few months and even into October, into the fourth quarter as well, that's persisted. So these businesses should, on the trading side at least be doing okay. But nothing else to add.
One of the big themes we've seen over the past few years is this shift in market share in that segment away from the Europeans towards those US banks that I've just mentioned, Goldman, Morgan Stanley, JP Morgan, and Citi. We've seen the likes of Deutsche, Credit Suisse in particular, but also UBS the French losing market share. When the Europeans report and Credit Suisse in particular next week, we're looking for a massive strategic review, some of which is being briefed out to the press. Strategic review could lead to Credit Suisse exiting some of these businesses to the benefit of those that remain. So it is an interesting market because on the one side, from a short-term perspective, you've got volatility, which drives earnings but from a longer-term perspective, thinking about strategic positioning and competitive positioning. I think you've got consolidation in this market with the withdrawal of some players and the concentration of market share amongst those that remain, which is fundamentally interesting for those players long term.
Impact of Technology on the Banking Sector
[00:34:43] Scott: Yeah. Yeah, I think that's a good point to move out like a medium-term, longer-term lens for this industry and sector. One of the things I think we see a lot from Jamie Dimon was, on top of this, I think Bank of America made a comment about this during their quarter as well, at this most recent earnings call, about the impact of technology on the banking sector. There are fintech competitors and that's one element of this, but also, in general, the way that customers are interacting with their banks using mobile apps more, and using chatbots for customer service. Those sorts of things are impacting. I think Goldman said they have 18,000 engineers in their bank now. I'm curious to get your thoughts on the kind of technology in banks and the fintech space and how innovation may or may not play out here. What do you think the medium-term looks like for this sector from that perspective?
[00:35:40] Marc: Banks spend more on technology than fintechs have raised in VC cumulatively over the past five years. They've never got the benefit for that, and there are cultural reasons why, in terms of their ability to recruit talent to work within tech at JP Morgan, let's say, compared to a startup. But as valuations have unwound in the fintech space and one prominent example that Eric will know well is Klarna whose valuation was cut by 85% plus in a recent funding round. And the impact of fintech, therefore, on their ability to retain talent given the derating of their currency could be quite substantial and remove one of the competitive advantages they had against the banks.
So the banks have been spending a lot on tech historically, they've got the reach. Bank of America when it reports earnings as it did this week, always has a slide on the number of digital customers and their ability to serve customers digitally. You mentioned Jamie Dimon, he's spoken in the past about how much they spend internally on technology. So I think the change in the environment that we've seen over the past year is probably the benefit of the banks medium-term to longer term. As it was in 2000, you go all the way back to 2000 and many similar sentiments we saw start-up banks then that disappeared. Traditional banks and incumbent banks were put under a lot of pressure but then as the market valuations changed, the competitive advantage of those startups depleted and banks came out okay. And I suspect the same thing will happen this time.
[00:37:33] Scott: Yeah, it's a super interesting point. I mean that statistic that you said of that they spend more in technology than all of the VC-backed fintech has raised cumulatively is one that is important. And I do think just as a consumer of these banks, the platforms have gotten pretty easy to deal with and it would be so hard to leave some of these brands, to make the decision to move large amounts of money away. One would think that they have a barrier of entry on those fronts, and then the regulatory barrier. Sounds like most of the cost of doing banking is just a regulatory barrier and that is supported by scale primarily.
[00:38:12] Marc: It's a good point. The way I think about that is there's an astute on growth, which is regulation that small enough size regulators grant a degree of forbearance. But as an institution gets bigger, it has to impose and put up much more regulatory controls in place, much more strict compliance controls. I'm closer to the fintech scene in the UK and you've seen that in the UK number of neo-banks have struggled. They've been able to win customers very cheaply without putting down compliance costs but then they get to a certain size and then not only is it harder to win customers beyond that size but also then the regulatory costs just go up non-linearly. They go up non-linearly and that's something that they underestimate the part of the curve before that, but hits them very hard subsequently.
[00:39:08] Scott: Yep. Eric, do you have any questions you want to jump in with?
[00:39:12] Mokaya: Yeah, I think two. One, there was a reference from I think Jamie Dimon about the amount of savings that consumers have running out specifically around mid-next year. I don't know if you caught that and what perspective you might have on that, and what role that may play as the recession nears. And secondly about stress in the financial system. There was a lot of talk about a lack of ability to intermediate in some situations for some banks. I don't know if you caught that also from the PT group. They said something about that. And since you're based in the UK Marc, you can specifically talk about the financial distress that you've seen. There was a lot of commentary in the banks’ earnings about the situation in the UK and how this might also extend to other banks and places, especially in the US those are the two questions I had for both you, Scott, and Marc.
[00:40:00] Marc: Yeah, on Jamie Dimon's comments, I've nothing to add, Eric. I think you're right. He did say that, and it reflects the point about deposits being drawn down and potential stress in store for the middle of next year. You write about financial distress, there are signs of distress. You could argue it's an inevitable consequence of high rates, and what we've seen in the UK there was a very specific catalyst for it, but something like that might have happened somewhere in the world anyway because there was a huge amount of leverage that was injected into the system as a result of multiple years of low rates and the system cannot withstand higher rates. It is as simple as that.
The only thing I would add though is that any stress, and it comes back to what I was saying before about Credit Suisse not being in trouble is that any stressful thing is probably going to be in the non-banks rather than the banks. Non-banks have grown rapidly since 2008 relative to the banks, and they're not regulated as intensively as banks. And that was the case in the UK with pension funds that struggled. They intermediate through various intermediaries, asset managers that run the pension funds, but it was the asset owners themselves, pension funds that struggled and likely what we're going to see elsewhere as well. So I'm looking very carefully at all of this stuff, but I think if there is going to be stress, it's more likely to be in non-banks than in banks.
[00:41:38] Mokaya: Yeah. I think there was a quote we picked up a while ago and they were appearing before a committee in Congress. The risks have shifted more to the non-banks. Scott, any thoughts on that?
[00:41:50] Scott: In terms of the non-bank risk?
[00:41:52] Mokaya: No, just about the recession
[00:41:54] Scott: Oh, yeah. I think what we're picking up, not only in the financial sector earnings calls but in the earnings calls in general that we're following is that we're seeing the likelihood of recession picking up here. We touched on a lot of different things on this call and appreciate Marc, your insights into this. This was helpful. I think the loan loss reserves piece is a part that can swing bank earnings. And I think right now none of us know how deep of a recession we're going into. I'm sure there are some people who think we're not going into a recession at all. But at any rate, whatever the depth of the recession or lack thereof we're going into, that's going to swing bank earnings a lot going forward. And I think we're at a place probably with respect to valuation and the market generally, bank stocks at least maybe become a little bit more sensitive to the economic outlook.
I think they had been trading at such a discount to market valuation for such a long time. I was looking at Wells Fargo recently, it looked like it was outperforming what happened to the broad market to date. And so some of these dynamics in terms of rising interest rates, the way that the yield curve is shaped and how that's impacting securities portfolios, the loan loss reserving, those sorts of things, one might expect that if we do have another leg down in equity markets, that financial equities could get dragged down along with that in a little bit greater severity along with some of the other assets that are priced for a lower interest rate environment. Yeah, those conversations help shed a lot of light on some of those dynamics that could come into play.
[00:43:30] Mokaya: All right. Maybe you can give some closing thoughts and also give a bit of outlook for the rest of the earning season which will be coming early next year in terms of reserves. You can start with Brian, who's been quiet and then you come to Scott and Marc. Brian.
[00:43:46] Brian: I'm good Eric. Thanks.
[00:43:48] Mokaya: Alright then Marc and Scotts
[00:43:50] Marc: Well, go on Scott, you'll be looking at non-banks.
[00:43:52] Scott: Yeah, one of the nice things about reading transcripts, the way that we do it at The Transcript is that the transcripts become dynamic with the environment too. So we see week to week as the news flow changes, that even if a company is scheduled to report earnings at a given time, they'll have a slightly different view of what the environment is just based on where they are on the calendar. So I think there's a lot of dynamics happening in the global economy right now. A week or two from now, we could be looking at a slightly different picture than what we're looking at today. And as non-banks start to report we'll be looking for dynamics with the consumer. The dynamics of corporate investing are going to be important. And, the focus is on what's the earnings outlook for the companies that we're following. So those are some of the things that we'll be looking at. Marc, what do you think?
[00:44:42] Marc: Yeah it's a very interesting point that you make about the dynamic response to what's going on. I'll be looking at Europeans. We've seen one or two of them. We've seen some of the scans. Some of the Swedish banks reported already, similar trends to the US, with very strong net interest income. No real stress yet in terms of credit, but I'll be looking at the European banks as they start to report next week.
[00:45:05] Scott: Awesome. I want to thank you again so much, Marc, for stopping by. This has been a great conversation. We'd love to continue it in future quarters. Brian, thanks for stopping by as well. Eric, any other thoughts?
[00:45:18]Mokaya: Thanks. No, I think that's a good place to close up. If you are on the call today and you'd like to be getting more insight from earnings calls, please follow us and subscribe to a newsletter at thetranscript.substack.com. Marc can be found at netinterest.co. A very insightful newsletter that he has on banks generally and the financial sectors. On that note, we close today. I see you again perhaps late next month for a Q3 wrap-up in terms of all the key thoughts and quotes that we'll have picked up from the earnings calls. So on that note, thank you, and have a good evening.
Share this post