Banks globally have been one of the worst-performing parts of the stock market since the COVID-19 pandemic hit, especially US Banks. The main reason US banks have done so poorly in recent months is that they could face a wave of loan defaults if elevated unemployment persists. Banks have already set aside billions this year to cover expected as well as unexpected loan losses, but if the pandemic worsens or government support dries up, it might not be enough. In addition, interest rates have fallen to record lows as a result of the pandemic, which is bad news for banks.
As such, let’s explore why they’ve underperformed and how the pandemic has affected, as well as how it could continue to impact, their businesses. In this article, we will be covering the 3 main US banks namely JP Morgan, Wells Fargo, and Bank of America.
How Banks Traditionally Make Money
Banks have been around for the longest time ever, but many of us may still don’t exactly know how they work. Most people do their banking at a commercial bank, a financial institution that provides services such as checking accounts, offering loans, and accepting deposits.
A customer deposits money into the banks, which provides them with the capital to make various types of loans. Commercial banks make money by earning interest income from loans such as mortgages, auto loans, business loans, and personal loans.
Banks also make money from service fees, varying based on the products. Some examples of these fees include monthly maintenance charges, minimum balance fees, overdraft fees, and non-sufficient funds (NSF) charges. For instance, Bank of America’s Advantage Savings Account charges a “fall below fee” if the minimum deposit balance in the account fell below $500.
Additionally, some banks also provide wealth management services as an additional income stream. Wealth management is concerned with providing financial services primarily for high net-worth individuals. For instance, one can start a Wealth Management program with Bank of America with a minimum of US$250,000 in Assets Under Management (AUM).
Depositing such large amounts in the bank once again provides capital for them to provide other services that would generate revenue for them. On top of that, banks make money by charging fees for the wealth management services they provide, such as selling managed account services and making discretionary investments on behalf of the client.
1H 2021 Performance
| Year on Year Difference | Revenue | Profit Before Allowances | Allowances Made | Net Profit |
|---|---|---|---|---|
| JP Morgan | $62.745 billion (+2.26%) | $26.353 billion (-4.61%) | $(6.441) billion | $26.248 billion (+247.56%) |
| Wells Fargo | $38.802 billion (+6.43%) | $8.368 billion (-21.12%) | $(2.308) billion | $10.676 billion (NM) |
| Bank of America | $44.287 billion (-1.79%) | $13.661 billion (-28.08%) | $(3.481) billion | $17.274 billion (+129.01%) |
Starting off with the US Banks’ 1H 2021 performance, we can see that all the banks have managed to improve year over year with Wells Fargo taking the lead in terms of revenue growth while Bank of America trails behind with a -1.79% growth in revenue. As we move into the next segment, we can see that the profit before allowances has dropped significantly because the banks have reduced most of the allowances made in the year prior, which will now be recognized in the income statement as an income item.
Looking at the net allowances made for 1H 2021, we can see that JP Morgan takes the lead with a net $6.441 billion decrease followed by Bank of America with a net $3.481 billion decrease and Wells Fargo trailing behind with a $2.308 billion decrease. Rounding it off, JP Morgan saw a 247.56% increase in its net profit year over year with Bank of America trailing behind with a 129.01% increase in its net profit year over year. As for Wells Fargo, because it made a net loss in the year prior, it is not possible to calculate the net growth and as such, has been noted with an “NM” or not meaningful.
5-Year Performance
With the Covid-19 crisis, interest rates are lower and credit risks are high. This results in the bank sector going down and sideways. That being said, we have to compare the financial performance of the 3 banks (JPM, Wells Fargo, and BAC) over the past 3-5 years to deem if they are a worthy investment.
Total Revenue
| Total Revenue ($b) | FY2016 | FY2017 | FY2018 | FY2019 | FY2020 |
|---|---|---|---|---|---|
| JP Morgan | $96.569 | $100.705 (+4.28%) | $109.029 (+8.27%) | $115.399 (+5.84%) | $119.543 (+3.59%) |
| Wells Fargo | $88.267 | $88.389 (+0.14%) | $86.408 (-2.24%) | $85.063 (-1.56%) | $72.34 (-14.96%) |
| Bank of America | $83.701 | $87.352 (+4.36%) | $91.247 (+4.46%) | $91.244 (+0.00%) | $85.528 (-6.26%) |
Jumping right into the operating performance, we can see that historically, all 3 banks have been able to consistently increase their revenues over the past 5 years with the exception of Wells Fargo, which has been struggling, seeing its revenue fall yearly. Diving into FY2020, we can see that all 3 banks were adversely affected by the Covid-inflicted recession. However, JPMorgan is still the best performing bank amongst the 3, as it managed to have a leading net profit. JPMorgan was also the bank that was least affected by the Covid-19 inflicted recession.
Allowances Made
| Allowances Made ($b) | FY2016 | FY2017 | FY2018 | FY2019 | FY2020 |
|---|---|---|---|---|---|
| JP Morgan | $5.361 | $5.290 (-1.32%) | $4.871 (-7.92%) | $5.585 (+14.66%) | $17.48 (+212.98%) |
| Wells Fargo | $11.419 | $11.004 (-3.63%) | $9.775 (-11.17%) | $2.687 (-72.51%) | $14.129 (+425.83%) |
| Bank of America | $3.597 | $3.396 (-5.59%) | $3.282 (-3.36%) | $3.590 (+9.38%) | $11.32 (+215.32%) |
Now, revenue is definitely important but with 2020 being such a shaky year, the 3 US banks had to make a ton of allowances to account for possible bad debts. Looking at the table, we can see that historically, all 3 banks have been rather consistent with their allowances made with the exception of Wells Fargo, which has been trying to lower its allowances made year over year since FY2016. Moving into FY2020, JPMorgan made the largest amount of allowances, at a fairly conservative amount of $17,480 (in millions, USD). However, the largest jump of allowances would be Wells Fargo, representing a 425.83% growth from last year, followed by JPMorgan a 212.98%.
Net Profit
| Net Profit ($b) | FY2016 | FY2017 | FY2018 | FY2019 | FY2020 |
|---|---|---|---|---|---|
| JP Morgan | $24.733 | $24.441 (-1.18%) | $32.474 (+32.87%) | $36.431 (+12.19%) | $29.131 (-20.04%) |
| Wells Fargo | $21.938 | $22.183 (+1.12%) | $22.393 (+0.95%) | $19.549 (-12.70%) | $3.301 (-83.11%) |
| Bank of America | $17.822 | $18.232 (+2.30%) | $28.147 (+54.38%) | $27.430 (-2.55%) | $17.894 (-34.76%) |
Looking at net profits, we can see that there is a rather consistent growth for all 3 banks with JP Morgan and Bank of America taking the lead in terms of growth while Wells Fargo lacks behind. For FY2020, we can see a drastic fall in net profits for Well Fargos at 83.11%, while JPMorgan fell the least at 20.04%. From this, we can confidently say that JPMorgan performed the best.
Key Financial Metrics
| 5-Year Average | Net Interest Margin | Cost/Income Ratio | Non-Performing Loans Ratio | Liquidity Coverage Ratios (LCR) | Leverage Ratio | Common Equity Tier 1 |
|---|---|---|---|---|---|---|
| JP Morgan | 2.952% | 76.23% | 0.68% | 115.86% | 7.94% | 12.40% |
| Wells Fargo | 2.752% | 67.70% | 0.84% | 115.60% | 8.98% | 11.58% |
| Bank of America | 2.526% | 62.50% | 0.64% | 112.20% | 8.22% | 11.26% |
Moving onto key financial ratios, and this is definitely the most important part when analyzing and evaluating a bank. At first glance, JPMorgan seems to be beating its peers with a higher NIM and CET-1 Ratio. In terms of Cost/Income Ratio and NPL ratio, BAC seems to be the best-performing. Unfortunately, JPMorgan does lag behind its peers when it comes to the leverage ratio as well as the Cost/Income Ratio.
Based on the financial ratios, we can see that JPMorgan has performed the best with the strongest balance sheet and falling shortly behind Bank of America by a small margin and Wells Fargo coming in last.
Potential Growth Catalysts
Interest Rate Hike
The US adopts a monetary policy, where the interest rate is lowered or increased depending on each economy’s circumstance. An expansionary monetary policy is when the central bank increases money supply or lowers interest rate to make credit more easily available and borrowing cheaper, while a contractionary monetary policy is when the central bank reduces money supply or increases interest rate to limit the availability of credit and make borrowing more accessible.
Due to the 2019 Coronavirus-inflicted recession, central banks are set to spend 2021 maintaining a loose monetary policy although the global economy is expected to recover rapidly. According to Bloomberg’s quarterly review, no major western central bank is expected to hike interest rates this year. This makes credit more easily available and borrowing cheaper in the US.
As such, households are more likely to borrow to purchase big-ticket items and less incentivized to save as the rewards from saving have decreased significantly, and hence consumer spending rises. The lowered cost of borrowed funds used to finance projects makes them even more profitable than before, hence the increased investment in plants and machines as well as inventories.
As firms and households borrow more, banks stand to benefit because they can lend more and hence earn more interest income from loans. However, bank capital will also drop as households tend to save lesser, and bank profitability will be worsened as borrowing costs fall. Periods of recession will increase the number of debt households is willing to subject themselves to, which could be a problem for both banks and households when interest rates begin to rise in the future.
Reduction in Allowances Made
With the Covid-19 pandemic hitting hard on the economy, banks around the world were mandated by their respective governments and agencies to ensure that there was sufficient liquidity in the bank should they incur a massive chunk of bad debt. As a result, we saw US banks increase their allowances made by a huge margin to err on the safe side.
As the global economy starts to recover gradually with the mass distribution of vaccines, we can definitely expect these tight measures to loosen up. Banks definitely stand to gain here because allowances made are not actually expenses incurred. In accounting terms, allowances made are loans that the bank thinks will turn delinquent and are erring on the safe side, deeming it a loss incurred.
Should these loans turn out to be fine and are paid back to the bank, they will be recorded back into the income statement so that it becomes a net net. If the loans turn out delinquent, the banks have already accounted for it as an expense so it will not show up twice. If banks start to reduce the amount of allowances made, we can expect to see a significant increase in their revenue moving forward.
Valuation v. Peers
| Annualized PE Ratio | PB Ratio | Dividend Yield | Pre-Cap FY2020 Dividend Yield | 5-Year Average ROCE | |
|---|---|---|---|---|---|
| JP Morgan @ $150.93 | 9.98x | 1.78x | 2.38% | 1.67% ($2.52) | 11.92% |
| Wells Fargo @ $45.03 | 8.16x | 1.08x | 0.89% | 1.90% ($0.854) | 9.24% |
| Bank of America @ $37.96 | 9.21x | 1.27x | 1.90% | 1.33% ($0.504) | 8.38% |
Jumping right into the valuation of the 3 US banks based on the last closing price, we can see that Wells Fargo is the best value pick right now with the lowest PE and PB ratio. Despite that, in terms of dividend yield, it does lack behind its peers by a significant margin. On top of that, Wells Fargo is the only bank that has not increased its dividend above its FY2020 payout. Both JP Morgan and Bank of America have seen a huge increase in terms of dividend payout for FY2021 and investors can definitely expect more growth to come as the banks continue to maneuver out of the pandemic situation and ride on the recovery of the economy.
Final Thoughts
Optimistically speaking, the good news is that things are probably getting better thanks to the widespread vaccine distribution, which decreases one’s chance of getting infected. More cities and towns in the US are opening up, which means higher induced consumption and the need for more capital. Flooded with government stimulus packages, this has driven long-term interest rates higher, which is a catalyst for the aforementioned US banks to recover. The Federal Reserve has committed to keeping short-term interest rates low, which will benefit consumers and hence improve spending in the short run.
All in all, the 3 US Banks namely JP Morgan, Wells Fargo, and Bank of America have seen great recovery thus far 6 months into FY2021. Coupled with their strong track record for the past 5 years, investors can be confident in the 3 US banks’ ability to not only survive this pandemic situation but come out stronger. We have already seen a sneak preview into this for JP Morgan and Bank of America as both banks have already paid out dividends far surpassing their peak in FY2020.