US Banks Performance: Stormy waters still on the horizon

1. US Banks Performance (Q2 2020) Beats estimates albeit Main Street suffers

2. US Banks Performance: Stormy waters still on the horizon • We analyzed the six largest banks’ performance in Q2 2020. The six banks selected were JP Morgan, Morgan Stanley, Goldman Sachs, Wells Fargo, Bank of America and Citigroup. • US banks have been very prudent in terms of creating provisions for the expected losses while have seen a bonanza surge in non-fee incomes courtesy higher trading volumes (in part driven by more retail participation) and higher capital market issuances (thanks to the Fed!) • The Fed has ventured into unchartered territories during the current crisis both in terms of the scale and scope of the response. That it will need to unwind the stimulus gradually is a given and there in lies the greatest uncertainty on how the post pandemic economy will look – how many businesses will survive, how many jobs will be regained or permanently lost. This will have a direct bearing on the banks’ loan portfolio • With the increase in issuances and trading volumes tapering off, banks’ fortunes are more tied to loss realization on their lending portfolios • A large proportion of lending is retail and high-yield nature, meaning there is a higher probability of default • So far, the banks have not felt the impact of the economic slowdown – although ~18 mn Americans were unemployed at the end of June 2020, defaults have been low thanks to the one-time increase in the stimulus cheques among other unemployment benefits • The banks are treading in unchartered waters. In a regular economic shock, unemployment and delinquencies rise as GDP, income, savings and asset prices go down. However, in the current crisis, although unemployment has increased and GDP has shrunk, incomes and asset prices have held up. • Banks’ fortunes appear to be closely tied with the infection curve, Fed stimulus and its eventual unwinding

3. This phenomenon is unique to US as large European counterparts continue to struggle • European banks have not been as cautious as their US counterparts in terms of provisioning with an average provisioning of just under 1% compared to more than 2% of the average for the six banks analyzed • Despite that, they have shown poorer performance in Q2 2020 compared to the US banks. HSBC, Europe’s largest bank, reported 88% decline in pre-tax profits in Q2 while other large lenders – Deutsche Bank, Santander and Société Générale have reported losses • European banks’ lower provisions is also driven in part by their weaker balance sheets. According to Oliver Wyman, European banks’ return on tangible equity averaged 6% at the start of the year, compared to 11.4% for the six banks analyzed • On the flip-side, majority of European lending is collateral-based, which implies that defaults are likely to be lower with a higher recovery rate • The European lenders did see a pick-up in trading revenues (BNP Paribas reported 154% jump in trading fees in Q2 2020), like their US counterparts but the Investment Banking activity in Europe was subdued • US banks face more regulatory hurdles, for instance ban on share buybacks and more prudent accounting rules (American banks are required to create expected provisions for all loans over their lifetimes while European banks need to create provisions for lifetime losses only for loans closest to default) • However, despite these hurdles and the headwinds from the unrelenting pandemic infections and its impact on the economy, the US banks are much better placed than their European counterparts

4. Net profits of top banks lower but beat estimates in Q2 2020 Aggregate profits of top six banks analyzed reached USD 10.8 bn in Q2 2020, down 16% from the previous quarter Exhibit 1: Aggregate Income before Discontinued Operations & Extraordinary Items (USD billion) Source: Refinitiv

5. JP Morgan, Morgan Stanley & BofA reported a strong quarter Exhibit 2: Individual banks’ profit performance (USD billion) Source: Refinitiv

6. But Goldman Sachs, Citigroup & Wells Fargo lagged behind • JP Morgan and Morgan Stanley saw a huge surge in Q2 income • Surprisingly all banks baring Wells Fargo reported positive earnings despite current poor economic conditions • Shrinking profits were expected as banks are forecast to create more provisions due to rising delinquencies • However, despite aggressive loan loss provisions, the results were unexpectedly positive Exhibit 3: Individual banks’ profit performance (USD billion) Source: Refinitiv

7. Coronavirus cases continue to surge Exhibit 4: Coronavirus daily new cases in the US Source: Worldometers/ Coronavirus

8. The economic slump can be witnessed in rising unemployment Although it is down from the peak in April 2020, it still hovers over 10% in July 2020 Exhibit 5: Unemployment rate (Aug 2019 – July 2020) Source: US Labor Department

9. The economic slowdown has led to higher loan loss provisioning by the banks Exhibit 6: Average Loan Loss Provisions as % of Loans by banks (Q2 2019 – Q2 2020) Source: Refinitiv

10. With all banks increasing provisioning in Q1 and Q2 2020 Exhibit 7: Individual banks’ loan loss provisions Source: Refinitiv

11. Reflecting the conservative approach by banks of the economic fallout on their loan book • All six banks have increased loan-loss provisions in 2020 ranging from 3.2% for Goldman Sachs to 0.7% for Morgan Stanley • At the beginning of the year, the average provisions stood at 1%, compared to 2.1% in the latest quarter reflecting banks’ prudent assumptions • At a LLP of 1.6% in Q2 2020, Wells Fargo maybe exposed to more downside risks since it has a bigger commercial lending unit than the other banks and may not have been as prudent as other lenders Exhibit 8: Individual banks’ loan loss provisions Source: Refinitiv

12. Volatility has increased Exhibit 9: VIX (July 2019 – July 2020) Source: CBOE Global Markets

13. Leading to higher trading volumes As volatility increased retail and corporate investors looked to reposition their portfolios Exhibit 10: Trading volumes in USD bn (July 2019 – July 2020) Source: CBOE Global Markets

14. Combined with higher Equity Issuances Companies have taken advantage advantage of the buoyant capital markets to issue more equity for stronger capitalization. Some of these were used to repay drawdowns taken at the beginning of the crisis Exhibit 11: New Equity Issuances(June 2019 – July 2020) Source: Securities Industry and Financial Markets Association

15. And higher corporate debt issuances • Taking advantage of low interest rates and government support, corporates issued loans at an unprecedented rate during the pandemic • However, the issuances appear to be tapering off since July Exhibit 12: Corporate Debt Issuances (June 2019 – July 2020) Source: Securities Industry and Financial Markets Association

16. Higher trading volume and issuances have led to higher fee-based income for banks, offsetting the rising LLPs Fee-based income for the six banks analyzed touched a record USD48.9 bn in Q2 2020, up 13.5%on the quarter and 14.3% yoy Exhibit 13: Banks’ aggregate fee based income (Q2 2019 – Q2 2020) Source: Refinitiv

17. Led by JP Morgan and Wells Fargo Exhibit 14: Individual banks’ aggregate fee-based income (USD billion) Source: Refinitiv

18. Goldman Sachs is the sole outlier • More than 90% of the increase in fee-based income is driven by JP Morgan alone • Wells Fargo, although it has a smaller Investment Banking and Asset Management divisions, also saw an increase in Q2 • Bank of America, has maintained fee-based income at between USD9 and 10 bn since the past six quarters • Citigroup clocked USD18 bn in fee-based income in the first half of 2020, which is two-thirds of its entire fee-based income for 2019 • While Morgan Stanley didn’t see a significant surge, it too has not witnessed any decline in fee-based income in the past six quarters Exhibit 15: Individual banks’ aggregate fee-based income (USD billion) Source: Refinitiv

19. Banks are in a strong position reflected in their core capital ratios Exhibit 16: Banks’ average core capital - Tier 1 ratio (Q2 2019 – Q2 2020) Source: Refinitiv

20. And declining but respectable Return on Equities Exhibit 17: Banks’ average ROE (Aug 2019 – July 2020) Source: Refinitiv

21. JP Morgan and Morgan Stanley look strongest Exhibit 18: Individual banks’ ROE and Core Capital ratios Core Capital ratios Return on Equity Source: Refinitiv

22. Wells Fargo has seen sharp dip in profitability but looks well capitalized Exhibit 20: Individual banks’ ROE and Core Capital ratios Core Capital ratios Return on Equity Source: Refinitiv

23. Citigroup and Goldman Sachs have strong CAR despite declining profits Exhibit 21: Individual banks’ ROE and Core Capital ratios Core Capital ratios Return on Equity Source: Refinitiv

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