How has the banking system changed over the last decade?

This week many of the major U.S banks reported earnings. These quarterly reports were exactly what they should be for a bank, which is very boring. They are reporting higher revenue and earnings than 1 year ago.  U.S. banks have now become cash cows.

There are still many investors who believe that banks can’t thrive when interest rates are low. These investors have failed to realize that the low interest rate environment has been a boon for profitability. Even though interest rates have been very low, banks are extremely profitable. In the past, banks had trouble making money when interest rates were low. This was because of something called net interest margin. The net interest margin for a bank is the interest rate spread between deposits and loans. The higher the spread, the higher a bank’s profits. This spread is very important for a bank. Banks can create more profit by borrowing cheap in the short-term and lending high in the long-term. They prefer a larger yield differential, or a “steeper” yield curve.

Bank stocks will tend to rise on days when interest rates rise. I believe that this is now the incorrect way to value a bank. If banks had it their way, they would prefer for the economy to be exactly the same way as it has been for the past 5 years. It is much more important that there is stable employment and a strong housing market. The low interest rate and slow growth economic backdrop have been a great combination for a bank’s profitability. Banks can now generate more income from fees and they rely less on the spread between interest rates.

Ten years ago, before the credit crisis hit, banks were highly leveraged, had lower capital ratios, and they didn’t have solid underwriting standards. Now fast forward a decade, banks have rebuilt their balance sheets, have tightened lending standards, and have diversified their revenue streams. The operations inside of a bank have also become much more efficient. Banks have closed branches, lowered headcount, while continuing to invest into technology.

A well-known bank analyst reported that banks are swimming in so much excess cash that they don’t know what to do with it. Most banks have been returning cash to shareholders in the form of rising dividends and share buybacks. The largest U.S banks are now buying back shares at a greater rate than many cash rich technology companies.  I expect that this pace of buybacks and dividend increases will only increase over the next few years.

I will continue to favor banks as long as the housing market stays strong and the unemployment rate remains low. I’m much less focused on falling or rising interest rates than most other investors. The banking system has helped to facilitate economic growth and should continue to do so as long as banks keep their future earnings reports very mundane.

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