The Taiwan Banker

The state of US markets for the past several months could be summarized as confusion. After reaching a peak around October, stocks experienced a sudden sell-off in December. The Federal Reserve, once committed to full interest rate and balance sheet normalization, recently reversed course in the face of a weak housing market and international environment. Stocks have resumed their rally (despite strong volatility), while bonds have been moving in the opposite direction. The recovery from the 2008 financial crisis, which in July will become the longest period in history without a recession, seems to be running out of steam, but it remains unknown how quickly and severely it will do so.The health of the banking sector reflects trends in the country as a whole. Banks are especially sensitive to interest rate trends and the investment environment. It is also important to understand the general corporate environment, as banks are affected by larger business and political trends. Change happens gradually, but particularly if a couple more years of growth can be squeezed out of the current economic respite, the industry might become almost unrecognizable over the course of a single business cycle.Disproportionate ReactionThe US economy is not in immediate trouble. Jamie Dimon, Chairman and CEO of JPMorgan Chase, wrote recently in a widely watched letter to shareholders that “in spite of all the uncertainty, the U.S. economy continues to grow in 2019, albeit more slowly than in 2018. Employment and wages are going up, inflation is moderate, financial markets are healthy, and consumer and business confidence remains strong, although down from all-time highs.” Nevertheless, “a fairly healthy U.S. economy will be confronting a wide variety of issues in 2020 and 2021. It’s hard to look at all the issues facing the world and not think that the range of possible outcomes is broader and that the odds of bad outcomes might be increasing.”Some have speculated that the tax cuts enacted in 2018 would give the economy a ‘sugar high’ that would quickly dissipate. Growth reached 4.2% in the second quarter of 2018, but declined to 2.2% in the fourth quarter, for total of 3% for 2018. Forecasters are estimating that 2019 will look more like the later part of the year than the earlier, anomalous result. In March, the interest rate yield curve inverted. Although this is a leading indicator of previous recessions, market observers including Dimon are skeptical of its predictive value this time, given the amount of central bank interference in this market cycle. Meanwhile, the trade war remains unresolved, and moves to politicize the central bank have exacerbated investor confusion, among other complicating factors. Inflation remains muted, though, so the central bank will not reverse course a second time in the near future. First quarter results shed some light on how business has held up since the start of the market gyrations last year. Citibank is seen to be the weakest of the four US mega-banks except for Wells Fargo (discussed below), with a sub-par performance at that time. It is also the most international of the main banks, which is relevant because the Fed’s recent U-turn is arguably related more to international uncertainty than a deterioration in the domestic economy. Citibank posted modest growth in deposits, and no growth in loans. Regionally, its consumer banking revenue in Asia is down over the past year, but it faced lower costs, including a decrease in effective tax rate from 24% a year earlier to 21%. Overall, the results were not stellar, but could have been worse.A Business Model for the FutureBanks are also keenly aware of slower-moving changes that have the potential to change their business model. They are in the process of moving away from traditional branch-based business to a disaggregated, online model in which they can select the most profitable segments to develop, making use of economies of scale. The number of bank branches has shrunk over 10% since 2008, and at an increasing rate since 2012. In this regard, it is useful to compare banking to the plight of other related sectors: retail and technology.The US media has used the term “retail apocalypse” to describe a process of brick-and-mortar stores closing down, driven mostly by increased online traffic. A report by UBS counts 15,000 closures since 2017, and predicts that 75,000 will close by 2026, including 17% of clothing retailers. Retail reflects emerging trends in banking as well, and the shift to E-commerce somewhat predated the spread of online banking. Clearly, to some extent, this reduction in branch count reflects the declining importance of geography. Some newer banks are focusing on highly segmented groups such as Silicon Valley, agriculture, non-profits, and Chinese Americans. Over the past 10 years, Bank of America reduced its consumer banking offering from 1,400 to 65 products. Another concurrent trend is a reduction in the total number of financial institutions. The US has a long tradition of community banking – small-scale locally managed banks that can typically develop deeper customer relationships and offer better rates for small businesses and consumers. The total number of institutions in the US declined from 7,309 in 2009 to 5,168 in 2018, mostly reflecting merger activity among the ‘long-tail’ of the smallest banks. Community banking is not ending, and this agglomeration shows that some of the reduction in branches simply reflects healthy elimination of redundancy, but there are some signs of harmful concentration in the sector.Renewed Regulatory PressureDigging into these numbers, the main problem is not failure of existing banks, but rather that almost no new banks are being formed. Smaller banks have long complained about the burdens under the Dodd-Frank Act. The Trump administration’s most significant act of bank regulatory reform so far has been to roll back some of the restrictions under that act, particularly targeting smaller banks. The banks are now given more leeway make investments that were previously considered “speculative.”Meanwhile, on the upper end of the spectrum, the largest banks have been increasingly pulling away from the pack. JP Morgan Chase, Bank of America, Citigroup, and Wells Fargo (in order from largest to smallest) each have over US$ 1.8 trillion in assets. US Bancorp, in fifth place, however, has under US$ 500 million. Over-concentration has become a target of growing concern in a variety of industries, especially among the Democratic opposition, which is searching for a signature issue to distinguish itself from the Republicans currently in power. Banks may expect more scrutiny as the 2020 presidential election approaches.Consumer watchdogs recently claimed one high-profile victim: CEO Timothy Sloan of Wells Fargo resigned on March 28 after withstanding sustained regulatory criticism over previous fraudulent activity. (Sloan himself had served as chief operating officer at the time of the violations.) In early 2018, the Federal Reserve had taken the unprecedented step of limiting its asset size to US$ 2 trillion until further approval. Regulators have long shied away from interfering in companies’ personnel decisions, considering that to be an internal matter, but this episode demonstrates bolder use of enforcement measures, which could become more of a trend as suspicion of market power grows.The US has a self-styled reputation as being a haven for free markets, but it also has a history of using certain powerful regulations to great effect. One such rule prohibits non-banks like technology companies from taking deposits. This rule has prevented giants like Amazon from entering the banking sector so far, but their possible entrance into the sector via partnerships with banks remains an important point to watch in 2019. The World Economic Forum has warned that allowing technology giants to control the pace of innovation – which could eventually also include controlling the branding of the joint products – could create long-term challenges for the banking industry. These players now appear to be a more potent threat to banks than fledgling startups. That is to say, it is not the technology by itself that’s a threat, but rather the ability to amass a broad user base and respond quickly to consumer demand.The economy is proving exceptionally difficult to read at present, but these are the sorts of developments with more long-term potential to reshape the industry, no matter the weather report.