What Do Big Bank Earnings Signal for the Economy?

The biggest banks in the United States recently kicked off quarterly earnings season and the results were kind of boring, which, for investors, is something to be excited about.

J.P. Morgan Chase kicked it all off Friday, reporting record first-quarter profit and revenue that exceeded analyst expectations. Wells Fargo, Goldman Sachs, Citi and Bank of America followed with mixed, but overall solid, results that largely met expectations. As our experts dive into the numbers, they’re finding plenty of reasons to remain optimistic about the economy.

“Really, what we saw the past week was more of the same. Credit quality remains steady — consumer and commercial loans on the books continue to perform in line with recent trends and the banks continue to show good expense discipline,” says Matthew Stucky, CFA, an equity portfolio manager at Northwestern Mutual. “The takeaway, if you look at all the earnings reports, is that credit trends remain very benign. We’re not seeing stress from the consumer side of things in terms of their ability to pay back loans.”

Typically, a recession is preceded by financial weakness in the banking sector or a weak consumer. The financial crisis was a double-barreled headache as both the banks and consumers were wiped out by toxic mortgages that brought the economy to its knees. Consumers took on mortgages they could never afford, and the banks bundled thousands of those mortgages into tradable investments that backfired mightily as defaults soared. Fast forward 11 years, and banks and consumers are in an enviable position: they’re both going strong, and that bodes well for this economic expansion’s continued longevity.

DULL DELINQUENCIES

Stucky and team were closely watching one metric for signs of economic trouble: the delinquency rate, or the percentage of a bank’s loans in which the borrower is at least 30 days behind on payment. For the past two years, delinquency rates at the major banks have barely budged, fluctuating up and down within a range that Stucky considers statistical noise rather than signs of a trend in one direction or the other. This is important, because a sudden uptick in loan delinquency rates is often an omen that the credit cycle — the tendency for loan performance to deteriorate at the end of an economic cycle — is starting to take a turn for the worse. But Stucky saw nothing that concerned him in the first-quarter numbers.

“It’s boring, and that’s beautiful,” says Stucky.

Because delinquency rates are so low, the banks are generating healthy returns on their loans, which, in turn, makes it easier for them to continue lending more. That triggers a virtuous cycle for the rest of the economy, as consumers and businesses alike can borrow money at affordable rates to make big purchases or invest in their businesses to boost productivity. Case in point: Bank of America CEO Bryan Moynihan earlier in April said his bank would issue $5 billion in mortgages aimed at helping low- to moderate-income families become homeowners.

In contrast, a spike in delinquency rates could signal consumers are under increasing financial stress and struggling to pay their debts. That would drive banks to be more selective about who they loan to, if at all. As it grows more difficult to get a loan, companies that need to borrow money to keep their operations going could run into financial trouble. You can imagine the rippling effects if a vicious cycle of loan defaults, bankruptcies and layoffs gained traction.

IN A POSITION OF STRENGTH

Fortunately, that latter situation doesn’t appear to be on the horizon. In addition to strong loan books, banks are also better capitalized than they’ve perhaps ever been. Essentially, banks have a lot more cash sitting in reserves to cover potential losses from loans and other investments that sour. The amount of reserves banks hold today dwarfs their pre-financial crisis levels. In fact, the big banks have so much cash they are getting permission to return more of it to shareholders in the form of dividends and buybacks, bolstering their stock prices.

“Banks are still holding a lot more capital than they really need to,” says Stucky. “For perspective, the amount of capital J.P. Morgan holds today could essentially cover the projected bank losses incurred by the largest 35 U.S. banks in the Federal Reserve's most severe stress test scenario three times — and that's just one bank."

The total amount of capital held by so-called strategically important financial institutions (SIFI) is over $2.2 trillion. A severe stress test scenario calls for losses of $139 billion.

"There's always the risk that losses could be higher, but there's a massive cushion that the banks have built up," Stucky added.

So, not only are consumers strong but the banks are financially stronger than they’ve been in a long time. Even when the next recession inevitably occurs — it’s not clear when — the banks should be better positioned to shelter themselves, and the broader economy, from the fallout.

There’s been quite a bit of discussion in the press about when this economic expansion will falter, especially given analysts’ expectations for a tough earnings season. But if you’re looking at the banks for signs of a stumble, you’re going to be awfully bored sifting through the numbers.