Themes From Bank Earnings

Last week was filled with second-quarter earnings reports from a number of major U.S. banks, and a few broad themes emerged: low domestic economic growth and a rising interest rate environment.  While the headlines read overwhelmingly positive, certain underlying trends actually indicate a slower growth outlook.  Loan growth was sluggish across the sector, with most banks reporting approximately 2% loan growth relative to the first quarter and less than 5% growth year/year.  Most of this growth took place on the commercial side, as consumer loan demand was tepid.  Deposit growth continued to increase, but banks differed in how they used these deposits.  For example, JP Morgan increased its cash balances held at the Fed in an effort to improve its capital ratios, while Wells Fargo added to its investment portfolio to boost its net interest margin.  The investment banking business fared well, and banks with capital market activities experienced higher earnings growth relative to those with strictly traditional banking models.  Overall credit quality is improving, and many banks were able to release reserves for credit losses, which helped boost bottom-line numbers.  Add everything together and the banking system is performing in  a similar manner to the overall economy: slowly and cautiously. The lack of loan growth corresponds to the lack of money velocity, which historically has been highly correlated with inflation.  Also, increased capital requirements from regulators are limiting loan activity, which is good for bondholders as balance sheets are strong and credit quality has improved.  This is one of the reasons that bank bonds have dramatically outperformed thus far in the third quarter.  The banking system is a leading indicator for economic growth and, from what we’ve seen, banks are not operating as if GDP is poised to surprise positive relative to expectations.  From a bondholder perspective, however, we don’t need rapid growth to experience improved credit quality and sector out-performance.