So far, we’ve discussed the basics of banking, the sector’s regulations in the US, as well as how interest rates, the shape of the yield curve, and state of the economy drive its performance. Let’s discuss a few more trends that are shaping the future of the sector.
Transition away from LIBOR
LIBOR (London Inter-bank Offered Rate) is the most frequently used interest rate benchmark around the world. In July 2017, the UK’s FCA (Financial Conduct Authority) announced that LIBOR may cease to exist in 2021.
One of the key reasons driving this change is the dwindling interbank transactions on which the rate is based. LIBOR is the estimated average rate that the panel of banks in London would charge for borrowing from other banks.
Globally, banks are facing the challenge of adopting an alternative benchmark to LIBOR. In the US, the Federal Reserve has begun publishing the SOFR (Secured Overnight Funding Rate) as an alternative to LIBOR.
The sector should find this transition very challenging, as it would need to change several contracts currently based on LIBOR. Moreover, the transition will be complex and may change banks’ risk profiles, valuation tools, product design, and the effectiveness of their hedging strategies.
The task would be more daunting for entities with international operations, as they deal with several benchmarks in various countries. Overall, the transition away from LIBOR is full of risks and uncertainties.
Technology and banking
Changes in technology have reshaped the sector. Banks are increasingly collaborating with fintech firms to improve the customer service experience. In retail banking, online lending platforms and mobile banking usage is on the rise.
Fintech firms such as PayPal have transformed the way payments are made globally. Regulations such as PSD2 (Payment Services Directive 2) encourage innovation in the payments industry. Plus, banks need to innovate to prevent losing customers to other payment providers. In wealth management, robo advisory services have opened gates for mass-market customers with limited assets to invest.
Banks, especially the large ones, have recognized the key role of technology in growth. As an example, Bank of America (BAC) has invested around $25 billion in new technology initiatives since 2010. This includes building an internal cloud and software architecture.
BAC is using AI (artificial intelligence) to learn more about its clients’ needs. It has also launched peer-to-peer transfer capability on its mobile app, which allows customers of any bank to send money to one another in real-time.
Improved asset quality
Banks need to maintain loan loss allowances to cover potential losses in their loan portfolios. The allowance for loan losses for the industry rose after the 2008 financial crisis but has fallen significantly since then.
Delinquency rates—the ratio of the number of loans that have become overdue for payment, or have failed to pay, to the total number of loans made—have declined after the crisis across all loan categories.
Charge-offs, which are the value of loans removed from the books and written off against loss reserves, have also declined. As the asset quality has improved, banks are keeping aside a lower allowance for potential defaults. Improved asset quality means fewer charge-offs and higher profits for banks. Currently, the sector’s asset quality indicators look strong.
US banking stocks
The S&P 500 Index comprises 19 bank stocks. These stocks include five diversified banks—Bank of America (BAC), JPMorgan Chase (JPM), Wells Fargo (WFC), Citigroup (C), and US Bancorp (USB)—as well as 14 regional banks.
JPMorgan Chase is the largest bank in the US by market capitalization, followed by BAC. The chart above lists the S&P 500 banking stocks and their selected metrics.
The forward PE ratios in the table use the earnings estimates for the next year. BB&T (BBT) and SunTrust (STI) have announced a merger, which is expected to close in the third or fourth quarter of 2019.
Valuation and outlook
The financials sector typically trades at a lower valuation due to its relatively lower growth rate compared to other sectors. This sector is trading at a PE of approximately 14.8x compared to a market PE of approximately 20.5x. The financials sector of the S&P 500 Index comprises 68 stocks, including 19 banking stocks. The above graph shows the PE ratios by sector.
The banking sector has benefited from rising interest rates in the last few years. With the first rate cut after a decade in 2019, this tailwind may not last long. Due to President Trump’s policies, the sector has received a respite on the regulatory front. However, a global slowdown or recession may significantly hamper the sector’s performance going forward.
On the technology front, we expect to see growth in the banks that can successfully use technology to serve their customers. The banks falling behind, especially the smaller or regional ones, may see some consolidation.
The increased use of technology exposes the sector to risks, including those relating to cybersecurity and data protection. The banks will need to implement increasingly secure and sophisticated mechanisms to manage such risks effectively.
For the latest sector updates, please refer to Market Realist’s Financials page.