Bank Profitability to Rebound from Pandemic

The Covid-19 pandemic has been a defining experience for the U.S. banking industry – one that carries with it justifiable pride.

That’s the view of Thomas Michaud, CEO of investment banking firm Keefe Bruyette & Woods, who believes the banking industry deserves high marks for its performance during the pandemic. This is in sharp contrast to the global financial crisis, when banks were largely seen as part of the problem.

“Here, they were absolutely part of the solution,” Michaud says. “The way in which they offered remote access to their customers; the way that the government chose to use banks to deliver the Paycheck Protection Program funds and then administer them via the Small Business Administration is going to go down as one of the critical public-private partnership successes during a crisis.”

Michaud will provide his outlook for the banking industry in 2022 and beyond during the opening presentation at Bank Director’s Acquire or Be Acquired Conference. The conference runs Jan. 30 to Feb. 1, 2022, at the JW Marriott Desert Ridge Resort and Spa in Phoenix.

Unfortunately, the pandemic did have a negative impact on the industry’s profitability. U.S. gross domestic product plummeted 32.9% in the second quarter of 2020 as most of the nation went into lockdown mode, only to rebound 33.8% in the following quarter. Quarterly GDP has been moderately positive since then, and Michaud says the industry has recaptured a lot of its pre-pandemic profitability – but not all of it. “The industry pre-Covid was already running into a headwind,” he says. “There was a period where there was difficulty growing revenues, and it felt like earnings were stalling out.”

And then the pandemic hit. The combination of a highly accommodative monetary policy by the Federal Reserve Board, which cut interest rates while also pumping vast amounts of liquidity into the financial system, along with the CARES Act, which provided $2.2 trillion in stimulus payments to businesses and individuals, put the banking industry at a disadvantage. Michaud says the excess liquidity and de facto competition from the PPP helped drive down the industry’s net interest margin and brought revenue growth nearly to a halt.

Now for the good news. Michaud is confident that the industry’s profitability will rebound in 2022, and he points to three “inflection points” that should help drive its recovery. For starters, he expects loan demand to grow as government programs run off and the economy continues to expand. “The economy is going to keep growing and the pace of this recovery is a key part of driving loan demand,” he says.

Michaud also looks for industry NIMs to improve as the Federal Reserve tightens its monetary policy. The central bank has already begun to reverse its vast bond buying program, which was intended to inject liquidity into the economy. And most economists expect the Fed to begin raising interest rates this year, which currently hover around zero percent.

A third factor is Michaud’s anticipation that many banks will begin putting the excess deposits sitting on their balance sheets to more productive use. Prior to the pandemic, that excess funding averaged about 2.5%, Michaud says. Now it’s closer to 10%. “And I remember talking to CEOs at the beginning of Covid and they said, ‘Well, we think this cash is probably going to be temporary. We’re not brave enough to invest it yet,’” he says. At the time, many bank management teams felt the most prudent choice from a risk management perspective was to preserve that excess liquidity in case the economy worsened.

“Lo and behold, the growth in liquidity and deposits has kept coming,” Michaud says. “And so the banks are feeling more comfortable investing those proceeds, and it’s happening at a time when we’re likely to get some interest rate improvement.”

Add all of this up and Michaud expects to see an improvement in bank return on assets this year and into 2023. Banks should also see an increase in their returns on tangible common equity – although perhaps not to pre-pandemic levels. “We started the Covid period with a lot of excess capital and now we’ve only built it more,” he says.

Still, Michaud believes the industry will return to positive operating leverage – when revenues are growing at a faster rate than expenses – in 2022. “We also think it’s likely that bank earnings estimates are too low, and usually rising earnings estimates are good for bank stocks,” he says.

In other words, better days are ahead for the banking industry.