Corporate earnings season kicked off on Tuesday. First up were the Q2 results from three of the major US banks: JPMorgan, Wells Fargo, and Citigroup.
They all reported significantly lower results compared to the prior year. This isn’t really surprising considering we expect most companies to have been affected by COVID over the last quarter.
However, banks, in particular, are likely to report exceptionally poor results. In fact, there is a worry that this will continue for quite some time.
US major banks report at the beginning of the season. But other major banks across the world will likely follow a similar pattern.
We’re actually more worried about the major banks in Europe since they were already under severe pressure before the pandemic started.
Banks are mostly considered an essential service. And finance is one of the easier sectors to move to work-from-home. So it might not be initially all that clear why banks are likely to be the most impacted by COVID.
However, banks have a unique business model. And this leaves them open to a one-two punch that will drag down their earnings in the near future.
Banks need to account for loans that aren’t paid back. Typically, they set aside a certain amount of money each earnings period to have enough resources to write down losses from people who will be unable to pay their loans in the future.
This is necessary in order to maintain their capital reserve ratios within legal limits, and continue to be able to provide money to their customers.
With so many borrowers potentially either not being able to pay their loans, or need to have a portion of their loans written off, banks are setting aside record amounts of provisions in anticipation.
Just the first three banks mentioned earlier have set aside a combined $28B to deal with potential loan losses. Setting this money aside means it doesn’t count towards earnings.
Low Interest Rates
When central banks lower their target rates, the idea is that lower interest rates are passed on to the general public. The first implication is that banks charge lower interest rates to their customers.
Banks make money by charging customers a higher rate than the interbank interest rate they borrow from. As interest rates fall, the difference they can charge compresses, and they have lower revenue.
Secondly, lower interest rates being paid on deposits mean that people are not interested in giving money to banks. Without deposits, banks have fewer funds available to use as a reserve on which to issue loans.
Therefore, this further compresses their earnings potential. Often, banks try to compensate for this by increasing fees.
It’s a Long Road Ahead
To make matters worse, many central banks are putting caps on the number of money banks can return to their investors in the form of dividends and buybacks. Without an organic increase in the value of stocks and lower earnings potential for at least the next year, the growth outlook for bank equities is somber.