US banks – a return to health, strength and confidence

There’s no doubt about it, US banks have had a tough time over the last decade. However, some believe that it hasn’t been tough enough in terms of being held to account for their past misdemeanours! After almost a decade of tighter regulation (the Dodd-Frank Act and Basel III enacted) forcing banks to rebuild capital, we ask is the tide now turning the other way?

US banks are displaying an improvement in profitability and overall financial health. This coincides with the Trump administration claiming they are keen on rolling back some elements of financial regulation believing a softer approach will promote faster growth across the economy, a stance many agree with.

With the climate seemingly turning more favourable for bank management, there is a move afoot to allow banks to step up the amount of money paid back to shareholders. From announcements this and next week, US banks are hoping to be allowed to return $170bn to investors through dividends and share buybacks. This would take place over the coming four quarters and represents a whopping 25% increase, provided they pass a two-part stress test. In the first round of stress testing on Thursday, the Federal Reserve (Fed) reported that “the nation’s largest bank holding companies are strongly capitalized and would be able to lend during a severe global recession”. The severe scenario includes US employment rate rising by 6% to 10% level along with a steepening Treasury yield curve.

Looking back, we know that US banks reintroduced dividends after the 2007 global crisis much faster than those in other countries facing similar problems. This is because US banks were faster to restructure. However, with the boosted probability of the record pay-outs following the first stress testing round, it would be the first time bank are being allowed to return more money to investors than they will have earned in normalised profits. This is represented in the chart below.

Forecast Gross Dividends and Buybacks as a % of Profits

Source: Credit Suisse; FT, Data as of June 2018

US banking is one of many sectors benefiting from President Trump’s fiscal stimulus, primarily through tax cuts. A lower tax bill amounts to a saving of $3.6bn in the first quarter of 2018 alone. At the same time US banks are looking to repatriate cash from overseas putting it to use domestically – America First!

The health of the US economy and its ability to withstand interest rate hikes from the Fed have steered an increased level of confidence between consumers and businesses. This is evident from a pickup in trading revenue and increased velocity of money. US banks’ profits have been boosted by a steep yield curve. This occurs when the difference (spread) between short-dated and long-dated Treasury yields widens. This benefits banks because profits grow faster when spreads are wide. However, spreads have been narrowing which means banks are more reliant on volumes picking up.

US 2 and 10-year Treasury Yield Spreads Since 2006

Source: Bloomberg, Data as of 21 June 2018

The decision to allow banks to once again overdistribute is being criticised by many stakeholders. Their main concern is that it is too early following the hangover cure implemented in response to bad behaviour leading up to the crisis. Paying out more than they earn is happening at a time when the yield curve is flattening. As a result, critics say this may encourage even more bank lending to make up for less profits earned from spread lending. Health, strength and confidence is entrenched in the US banking sector.