The second quarter of banking sector earnings saw a half of the major U.S. banks – Goldman Sachs (GS), Bank of America (BAC) and Citigroup (C) – exceed Wall Street expectations, while the other half missed the estimates. One thing that was common among all was the growing net interest income as a positive effect of the hiked lending rates. However, the banks also saw a steep decline in their profits from the prior year due to greater provisions for credit losses and a slowdown in dealmaking activity.

Exhibit 1: Major U.S. Banks’ Q2 2022 Revenue and Profits

Source: Company Financials, July 2022; Market expectations data from Refinitiv

Higher lending rates boost net interest income of banks

Net interest income is the primary source of revenue for a bank. It is the difference between the interest earned from lending activities and the interest paid to depositors. Thus, it is primarily affected by two factors: interest rates and loan growth. To control surging inflation, the Fed has already lifted rates by 1.5 percentage points so far this year. This coupled with a swelling loan book has helped banks earn higher net interest income than the last year. 

Exhibit 2: Net Interest Income Q2 2021 vs Q2 2022 (in $ billion)

Source: Company Financials, July 2022

Steady loan growth in the second quarter

Demand for loans has remained resilient in the second quarter even in the face of rising interest rates, as consumers continue to spend and companies carry on bulking up their inventories. JP Morgan (JPM) and Wells Fargo (WFC) reported that their loan books grew 7% and 8.4%, respectively, during Q2 2022 compared to last year. Morgan Stanley (MS) saw its loans grow by $7 billion year-on-year.

Citigroup, Wells Fargo and JP Morgan said corporate clients borrowed more in the second quarter to cover rising costs due to increasing inflation. For Citigroup, gross loan yield rose for five consecutive quarters to reach 5.81% in the second quarter and the commercial loans are showing the best growth in 14 years. Even though declining mortgage lending was a drag on the consumer lending business, credit card loans grew, as Wells Fargo and JP Morgan both witnessed a 17% rise.

Fixed income trading revenues climb on the back of higher market volatility

Market volatility is not always a bad thing as it has helped banks earn higher fixed income trading revenue in such uncertain times. The three banks that beat second-quarter revenue expectations – Goldman Sachs, Citigroup and Bank of America – reported a 55%, 31% and 19% jump in bond trading revenue, respectively. Morgan Stanley, Goldman Sachs’ closest rival, also posted a 49% revenue growth in the same business over the same period. JP Morgan and Wells Fargo added 15% and 5%, respectively, in fixed income trading revenue. 

Higher provisions weigh down bank profits

The decline in profits across the sector reflects an increase in reserves for potential loan losses, which in turn raises the overall credit costs of a bank. Last year, government stimulus and economic recovery from the pandemic had allowed the banks to release funds from reserves. This year, however, banks took a U-turn and began building back provisions for probable defaults as the likelihood of a recession has increased.

Exhibit 3: Provisions for Credit Losses 2Q2021 vs 2Q2021 (in $ millions)

Source: Company Financials, July 2022

Slowdown in M&A and IPO activity hurts investment banking revenues

Economic uncertainties have hit dealmaking activity around the world. As per Ernst & Young, global mergers and acquisitions activity in the first half of 2022 dropped 27% by value and 18% by volume, compared to last year. In addition, the global IPO market also witnessed a dramatic slowdown so far this year after a record year for IPOs seen in 2021. While global IPO volumes nearly halved, proceeds were reduced by 58% in the 1H2022, as against 1H2021.

Exhibit 4:  U.S. IPO Volume from 2009 to Q2 2022

Source: Bloomberg, 28 June 2022

Poor post-IPO share price performance and increased volatility due to the geopolitical crisis has postponed many initial public offerings. So far this year, companies have raised merely $4.9 billion via U.S. listings. This is less than 6% of the record amount raised in the first half of last year. As a result, banks reported a double-digit decline in their investment banking revenues.

Exhibit 5: Y-o-Y Change in Investment Banking Revenue (2Q2021 vs 2Q2022)

Source: Company Financials, July 2022

Banks well-positioned for any economic shock

The bank earnings have been hit by a slowdown in dealmaking activity and by the fear of an imminent recession. However, the U.S. banks are in a better position to withstand the economic shocks now since the 2007-2009 financial crisis. In the words of Morgan Stanley’s CEO James Gorman, “I think it’s important to say, though, it is not 2008 … This is a different type of financial stress in the system, and frankly the banking sector is much stronger.” He eased some worries around recession by adding that even if the United States heads into some form of recession it is unlikely to be “deep and dramatic.”

Last month, the big banks passed their annual stress test by the Fed and proved that they are much safer even if a recession hurts loan growth. As a result, banks like Goldman Sachs, Wells Fargo, Morgan Stanley and Bank of America raised their dividends. Dividend hikes are a bullish sign and indicate the management’s confidence in the business. Moreover, banks are likely to profit from higher lending rates as the Fed continues to battle inflation with a hawkish stance. In fact, JP Morgan executives expect loans to grow by the mid to high single digits this year.

Bank stocks – a good bet for the long term

From a long-term investment horizon, banks do have real potential upside and are available at cheaper valuations. According to Refinitiv data, S&P 500 bank index stocks are currently trading at about 9 times forward earnings estimates for the next 12 months, compared with their long-term average of 12.4 times. This makes banking stocks cheaper in comparison to the S&P 500 stocks that are trading at 16 times forward earnings.

Exhibit 6: Bank Stocks Price Performance with Consensus Analyst Rating and Price Target

Source: MSN Money, Prices as of 15 July 2022