The combination of the $ 1.9 trillion Covid-19 relief bill signed by President Joe Biden earlier this month, along with the rapid deployment of Covid-19 vaccines and the short-term focus of the Reserve federal employment rather than inflation, will create a period of unusually high profits for most US banks.
This window will be temporary and last maybe two or three years before profits return to more normal levels.
The rapid explosion in profits will give banks the opportunity to finally do what most have been too difficult financially to accomplish: transform their business models to stay relevant in the digital age. They have to get attached and do it now, with a sense of urgency, even if it means giving a little less to shareholders in the short term.
Windfall profits will come from three areas.
First, a growing economy will produce large volumes of loans. The shake-up in direct cash payments is expected to boost near-term GDP growth, which will be further fueled by pent-up demand in many sectors, from leisure and hospitality to retail and travel. Economists on average provide Growth of 6.5% of GDP for 2021, almost three times the average rate from 2010 to 2019. According to our estimates, a rebound in the growth of bank loans in 2021 to just the historical average of 5.4% compared to 2020’s 1.7% drop could add up to $ 6 billion to the industry’s pre-tax profits, or roughly 2% of the industry’s pre-tax profits in 2019.
Second, profit margins will widen. They were declining before the pandemic, with signs that the long post-Great Recession economic expansion was finally running out of steam. The Fed’s emergency short-term rate cut in early 2020 has helped to steepen the slope of the yield curve, or the difference between short and long-term interest rates. The curve has steepened even more in recent months.
With the Fed announcing in August 2020 that it was ready to accept moderate inflation for more jobs, short-term interest rates are expected to stay low in the near term. The result: a widening of net interest margins and therefore profits for lenders. Bank of America CEO Brian Moynihan, for example, Told Barron’s Last week he expected a substantial increase in income. While the full impact of wider net interest margins typically takes time to show up in bank loan portfolios, we believe a return to the fourth quarter 2019 level of 3.2% from the fourth quarter of 2020, 2.6%, could add an additional $ 22 billion to the industry. pre-tax profits, or about 8% of total profits for 2019.
The biggest impact will come from the banks which collect the income from their funds on rainy days. The industry nearly doubled its loan loss reserves from the fourth quarter of 2019 to the second quarter of 2020, setting aside about $ 114 billion for losses that, overall, did not materialize.
So far, banks have shown commendable prudence in reducing these reserves for the sake of the health of the economy. But the combination of a better-than-expected Covid-19 vaccine rollout, unprecedented fiscal stimulus and positive employment trends are positively impacting credit performance. Banks will have no choice but to draw on their reserves. These reserves are recovered revenues that go directly to the bottom line. Based on our analysis of regulatory data, we estimate that banks could add up to $ 83 billion in pre-tax revenue over the next few years from this source, or roughly 30% of the industry’s pre-tax profits. in 2019.
In total, the industry could record up to $ 111 billion in additional profits over the next few years, or roughly 40% of the industry’s pre-tax total in 2019.
The question is: what will the banks do with all this money?
After the last recession, executives had no choice but to use the profits to rebuild their capital. But industry capital levels have remained high during the Covid-19 recession. This time, the choice of management and boards will be to return the capital to the shareholders, to invest in the future, or a combination of the two.
While the temptation will be strong to please short-term shareholders via share buybacks and dividends, pursuing this choice alone would be a mistake.
For years, weak profit growth has prevented many banks from investing in true digital transformation. Meanwhile, the demand for modern digital innovations for savings, spending, loans, investments and financial advice has exploded, especially since the start of the pandemic. Fintechs and large, digitally sophisticated high-tech companies are increasingly closing the gap, jeopardizing the long-term competitiveness of banks. Banks face a challenge – quickly.
The good news is that an unexpected wave of profits is on the way. It will be short-lived as the Fed’s jobs targets materialize and eventually take its thumb off short-term rates. This is a golden opportunity for banks to invest heavily in digital competitiveness. In a year or two, it will be too late.
Dan Rosenbaum is a partner in Oliver Wyman’s practices for retail, corporate banking and digital technologies, based in San Francisco, and a former equity analyst. Dennis Chira is a Director and Chief of Staff of Oliver Wyman’s Retail and Business Banking Practice based in Boston.