TFIRST The fact of the impact of the coronavirus on the financial markets and the banking system of the United States was characterized by panic. As companies rushed to accumulate the cash they needed to survive the closings, they rushed to sell their holdings of securities and withdraw their revolving lines of credit. Traders trying to market from their couches were overwhelmed with record volumes. Bank loan books and deposit accounts increased. Risk managers frantically tried to calculate potential credit losses. All this was reflected in the first quarter earnings of the big banks, reported in mid-April. Commercial profits were soaring, raising the income of investment banking. But financial results suffered when commercial banks set aside reserves to prepare for possible credit losses (see chart).
The second act was less turbulent, as government support quelled panic. Legislation passed in March strengthened unemployment benefits, established a small business loan scheme, and provided support for the Federal Reserve to buy corporate debt. This appears to have isolated businesses and households from much of the damage, and has restored order in financial markets. But uneasiness about the future remains. This dynamic was evident in the second quarter earnings presented by Citigroup, Goldman Sachs, JPMorgan Chase and Wells Fargo, four of the largest banks in the United States, on July 14 and 15. (Bank of America and Morgan Stanley, the other major U.S. lenders, were to report on July 16, as The Economist went to press)
When bond markets started to work again, companies rushed to sell securities. In the United States, companies have issued more than $ 2 trillion in equity and debt, equivalent to 5% of the total value of corporate bonds outstanding and public equity, and an increase of nearly 50% over the year. Consequently, primary issuance revenues at the Big Four banks increased 56%, year-over-year, to $ 7.8 billion. Operators kept busy: Business revenue increased 70% for the year to a record high of $ 26.9 billion. That reflected increased customer activity as well as wider business margins, said Stephen Scherr, chief financial officer at Goldman Sachs.
More company bosses now tell investors they have enough cash to cover two or three year expenses. The newly recapitalized companies are paying revolving loans. Of JPMorgan’s $ 55 billion withdrawn in March, $ 39 billion has been paid.
Commercial banks are preparing for the impact of the crisis, but it is yet to come. Although 17.8 million Americans were unemployed at the end of June, few have defaulted so far, thanks to stimulus controls and unemployment benefits, and banks’ willingness to defer mortgage and credit card payments. The four banks’ repayments, that is, their delinquent loan repayments, increased just 22% to $ 4.9 billion in the second quarter, up from $ 3.9 billion during the same period in 2019. Conversely, $ 29.5 billion was established in addition to expected loss provisions, compared to just $ 3.9 billion in the same quarter of 2019. This reserve is in addition to the $ 20 billion that lenders reserved in the first quarter. The way to think about these provisions, said Jennifer Piepszak, chief financial officer at JPMorgan, is that “everything is in perspective, because we are not seeing it today.”
Will the third act of the crisis make the banks suffer big losses? A simple way to think about what will happen next is to divide the institutions into three parts: the investment bank, which has so far performed exceptionally well; loan provisions, which have been exceptionally expensive; and “everything else”, which includes asset and wealth management. The residual part of the business of the large banks has generally been remarkably stable. If investment bank loan loss and income provisions had been constant throughout the year, net income would have fallen by an average of just 1% at Citi, JPMorgan and Wells.
Therefore, the fate of banks’ profitability is likely to depend on the fate of the investment banking business and loan loss provisions. Investment banking income appears to decrease, if it has not already. Trading volumes decreased in June and early July from their highs in March and April. Jamie Dimon, CEO of JPMorgan, estimated that business revenue would “normalize” or even fall below normal later in the year.
Whether the provisions prove to be sufficient or not is far from clear. They are based on a series of assumptions that overlap each other. One is about the path the virus takes. Another is how that evolution affects unemployment and economic growth. Yet another concerns the size of any additional fiscal stimulus, and how consumers and businesses respond to it.
The banks’ base case appears to be in line with that of the Federal Reserve. The economy is expected to be smaller in late 2021 than it was in late 2019. The unemployment rate is expected to remain in double digits until the end of this year, before gradually falling. But the heads of the banks emphasized the fog of uncertainty that enveloped everything. “We are in a completely unpredictable environment,” said Michael Corbat, chief executive of Citi. “In a normal recession, unemployment increases, delinquencies increase, cancellations increase, home prices decrease, income decreases, savings decrease,” said Dimon. This time the usual relationships are not maintained. Even when unemployment has increased, for example, income has increased.
If investment banking revenues decline and banks continue to have to increase provisions, losses can accumulate in the third quarter. Wells Fargo was the only bank to lose in the second. That reflects its relatively small investment bank, as well as its special situation: It still operates under an asset cap imposed by regulators that has limited its growth, even when other lenders have skyrocketed. But another, more promising scenario is possible: government stimulus continues to keep delinquency rates low, and banks end up with mountains of surplus capital. That would be good news for shareholders. Even as the s &P Benchmark 500 has recovered, bank shares are one-third lower than at the beginning of the year. But the happy scenario is also based on the third act being the last one. With covid-19 cases on the rise, that seems increasingly unlikely. ■
This article appeared in the Finance and Economics section of the print edition under the title “A Banking Drama in Three Acts”
