American banks’ earnings will gauge customers’ financial health

THE HEALTH of America’s economy and that of its banks are closely intertwined. Sometimes, as in the global financial crisis of 2007-09, hazardous behaviour by the banks leads to the whole economy being laid low. But even when, as now, the banks are not the source of the country’s economic ills, their vital signs still tell you something about the broader picture—about the ability of people and businesses to repay debts, their willingness to borrow and the appetite of companies to raise capital in public markets. The banks’ third-quarter earnings season, which begins on October 13th, is the next opportunity to take the banks’ pulse and gauge how America’s economy is faring in its recovery from the ravages of covid-19.

The economic turmoil caused by the coronavirus has cut both ways for banks. Commercial banking (basically, the business of taking deposits and lending) has suffered as the economy slumped, but investment banking has boomed. As markets see-sawed when the pandemic took hold, investment banks’ trading volumes soared, because in volatility lies the chance of profit. In the second quarter, trading revenues at the biggest banks hit a record $26.9bn, up by 70% year on year.

Banks’ bosses have expressed doubt that this bonanza could continue into the third quarter. But the astonishing run in tech stocks and the boom in public share offerings it has fuelled have probably kept moneymen busy over the summer. Morgan Stanley and Goldman Sachs, the two big banks that make most of their revenue from investment banking, may not repeat the second quarter’s blow-out, but are still expected to report growing revenues and steady profits in the third. (Though both have done well from investment banking this year, they have for some years been trying to reduce their dependence on it—Goldman by building a retail bank, Morgan Stanley by bulking up in asset management. On October 8th Morgan Stanley said it would buy Eaton Vance, an asset manager, for around $7bn in cash and shares.)

Strong investment-bank results have, so far, helped offset the damage from the real economy. In the first two quarters of 2020 America’s four biggest lenders wrote down the value of their assets by $50bn, as they made provisions for expected losses on loans. Bank of America, Citigroup and JPMorgan Chase, which have big investment banks as well as giant commercial banks, ended up in profit. At Wells Fargo, which does not, and at other, smaller banks, these write-downs resulted in losses in the second quarter.

The question now is whether actual loan losses will outstrip those provisions, or turn out to be less bleak than the banks have prepared for. In the past, slipping bank profits, partly reflecting provisions in anticipation of loans turning bad, have tended to be followed by the worst loan losses (see chart).

So far, no big losses have accrued, partly because of official measures to support the economy. Cash has been doled out to businesses through the Paycheck Protection Programme (PPP). Households have been handed payments of up to $3,400 and unemployment insurance was boosted by $600 per week. The Federal Reserve has kept policy super-loose (which has also gingered up the stockmarket). Charge-offs—ie, write-offs of loans in default—at the four biggest lenders rose by 22% year on year in the second quarter, but still amounted to just $4.9bn. The same was true of delinquent loans (those more than 30 days overdue) and charge-offs industry-wide, which hardly ticked up in the second quarter.

Whether loan defaults will climb more sharply depends on a couple of factors. One is the course of the economy. Most states have begun to reopen, permitting businesses to bring in more revenues than they were during the stricter isolation phase in early 2020. If recovery continues, they are more likely to pay their debts; if it stalls, they are likelier to default.

The other is the prospect of further economic stimulus from the federal government. The effects of the measures that kept consumers and businesses afloat through the summer will have faded in the third quarter. Five in six PPP borrowers said they had spent their entire loan by the end of August. The additional unemployment payments expired at the end of July. Democrats and Republicans in Congress have not yet agreed on a second support package. If they ever do, that may stop some anticipated losses materialising.

If losses do turn out to be smaller than expected banks, which already hold $2trn of equity capital, may end up sitting on a lot more—and far more than they need to satisfy regulatory requirements. But with the memory of 2007-09 still raw, the Fed wants them to keep their shock absorbers well padded. On September 30th the central bank said that the 33 banks with more than $100bn in total assets would remain barred from making share repurchases in the fourth quarter. Unlike banks in Europe, they are still paying dividends, but these will be capped at a level based on recent income.

Extra capital and the return of buybacks would be welcome news for banks’ shareholders, who have taken a beating in 2020. Even as the S&P 500 rallied to all-time highs through the summer, banks’ shares remained unloved. The KBW index, which contains a selection of the big listed banks, is worth 30% less than it was at the beginning of the year.

Banks are forking out some cash—but to the authorities. This week two will report the cost of regulatory infractions. On September 29th JPMorgan Chase agreed to pay almost $1bn to settle allegations of “spoofing”: market manipulation through fake trades. Then, on October 7th, Citigroup was fined $400m for failing to fix deficiencies in its risk-management system. These follow a $3bn fine Wells Fargo paid to settle its fake-accounts scandal in February and a $3.9bn settlement between Goldman Sachs and Malaysia in July for the bank’s role in the defrauding of 1MDB, an investment vehicle. Any more of this, and bank shares will surely remain unloved.