As the COVID-19 outbreak grew into a pandemic earlier this year, the U.S. economy was severely tested. How would it bridge the gap as one industry after the next was forced to curtail operations and, in some instances, essentially shut down?
Understandably, investors’ fears immediately turned to banks, which were seen as especially vulnerable to the diminished ability of borrowers to service their debts.
While we shared these fears, we noted in the spring that banks were much better equipped to handle this crisis than they had been during the global financial crisis (GFC) of 2008/2009. Back then, banks were especially vulnerable because the GFC was driven in part by excessive leverage on the part of U.S. consumers and the financial system more broadly. While those forces posed direct risks to banks, the impact of the pandemic is more widely dispersed, and we see the industry as part of the solution today.
Banks have become a catalyst for recovery
In our view, the U.S. banking system may be the healthiest it's ever been, with capital and liquidity levels near all-time highs in our assessment. In addition, today’s underwriting standards are much more stringent than they were before the GFC. Finally, banks have been continually stress tested by regulators relative to the pre-GFC period, when examinations of banks’ abilities to weather a potential economic crisis weren’t explicitly part of the regulatory regime.
As a result, we believe the U.S. banking system has recently played a critical role in helping the broader economy bridge the gap during the COVID-19 crisis by providing support through a broad array of loan deferrals to customers. Banks became the key transmission mechanism in providing Payment Protection Program (PPP) loans to small business customers as part of the unprecedented fiscal stimulus provided through the federal government. These loans provided a direct incentive for millions of businesses to keep their workers on payrolls rather than forcing them into unemployment.
Positive trends on loan deferrals
As the economy continues its process of reopening, we’re seeing a winding down in the temporary loan payment postponements and reductions that banks granted many customers―temporary relief known as forbearance. In fact, there are early signs that most of these loans can be returned to pre-crisis repayment schedules―a positive development for bank investors. Most banks granted either 90- or 180-day deferrals to borrowers beginning in late March or early April. These banks were willing to grant borrowers substantial leniency in the first round of deferrals, given the leeway that regulators gave banks to extend this relief amid the high economic uncertainty at that time.
Examples of this progress can be seen in recent disclosures regarding deferral rates from U.S. banks Regions Financial and Cadence Bancorporation. As of July 31, deferrals represented 2% of total loans at Regions, down from 6% a month earlier;1 at Cadence, deferrals represented 5% of total loans, down from 11% previously.2
Much of this improvement can be attributed to the fact that most borrowers who received an initial deferral didn’t request a second round of deferrals, which highlights a significantly positive development in borrower liquidity and sentiment. Disclosures from both banks indicated that they expected total deferrals to continue to trend down throughout the third quarter of 2020.1, 2 This gives us comfort that the loan loss reserves that banks are building today for future credit issues should address most problem areas. As a result, we expect U.S. banks’ 2021 earnings to rebound significantly.
Revenue and fee resiliency emerging from a crisis
Banks could see a further tailwind from their participation in the PPP, both from an earnings perspective and in retaining borrowers. Many of these loans have two-year durations, and we estimate that U.S. banks will receive about $15 billion in fees, with another $5 billion earned in interest for every year that PPP loans stay on bank balance sheets.
From a borrower perspective, this program provided tremendous relief to most businesses’ largest expense item—employees―and allowed employers to retain staff at a time when much of the country was in lockdown. This program allowed the banks to serve as a lighthouse in a storm for many of these small businesses, and it worked as a tremendous relationship-building exercise for banks to reconnect with borrowers. This potential benefit has been especially significant for smaller banks, many of which have boasted about acquiring new customers from larger banks, given that these larger institutions couldn’t process the volume of requests. In contrast, local loan officers at community and regional banks have been in better positions to support small- and middle-market businesses.
The recent trends we’ve seen in quarterly earnings reports, loan deferral data, and discussions with management teams have bolstered our belief that banks are well positioned to serve as long-term value generators even as they continue to confront uncertainty stemming from the pandemic and its economic impact.