Bank Profits Amidst Pandemic & Digital Disruption: Searching for the Groove of Scale

Banking sector earnings reports continue apace this week. Many industry players, large and small, are confronted by loan quality implications of the pandemic as well as side-effects from fiscal & monetary intervention meant to control economic contagion. It's the worst of all worlds in key respects--cycle and structure colliding as the bank balance sheet smashes into the income statement. Here's what we are learning from recent bank earnings reports:

Credit reserves must be built significantly for meaningful losses that will follow. However, we think the banking system can absorb this deep but temporary assault on profitability. Past measures to strengthen capital & enterprise risk management place the industry in a strong "going-in" position. Naturally some banks will fare better than others, but systemic risks appear tolerable thanks to swift & ample Federal Reserve actions joined by robust fiscal stimulus. In this way, we have been well served. Time heals all wounds.

Unfortunately, the pandemic is accelerating structural challenges to bank profitability arising from industry maturity, demographic changes, and technology developments forcing banks to re-tool product & service platforms to match customer preferences & emerging competitive threats. Digital transformation means Fintech ankle-biters are gaining capability, credibility, sponsorship, traction, scale, & share. No other industry has been able to escape similar disruption to product & distribution models. Banks are in the unenviable position of having to support old ways of doing business while "investing" in modernization. Its a world where "fast following" is rarely fast enough.

Alongside high credit costs & huge "renovation" budgets, the basic borrow-short-lend-long spread business has been pressured by competition, ultra-low interest rates & a flat yield curve. Which leads to an observation from one bank's conference call this morning & nearly every earnings call we have heard so far: the industry needs to take a sharper pencil to operating expenses in a life-or-death search for efficiency that will contrast those who muddle through with those who find the "groove of scale." Management spoke with resolve about their "laser focus on value for spend." Immediate stock reaction suggested the presence of doubters and naysayers, but value for spend is indeed the challenge and the objective. Spend has been ample. Value has been illusive.

"We hear you, but its easier said than done," is the mantra of the to-be-consolidated in this fragmented sector. The loss absorbing capacity of the banking industry & its centrality to community economic support reaffirm society's need for safe & sound financial intermediaries. But for how long can the banking industry dispense hard-fought "operating margin" into the P&Ls of risky borrowers (through narrow spreads and soft covenants), well paid consultants (with their high hourly costs for supplemental labor), & thriving technology vendors (with their enviable margins and scalability)?

Eventually, credit costs will fade. Competitive costs are here to stay. Banking is all about risk management. It might make sense to consider "risking" enhanced expense management, with language and execution similar to what we heard on the call of a major global financial institution last week:

"On the expense side, we remain focused on protecting our employees and supporting our customers. And we continue to feel good about the investments we are making, particularly in our digital capabilities and infrastructure and controls. That said, we continue to explore all opportunities to operate more efficiently to fund these investments and offset headwinds created by COVID-19. And overall, we still expect expenses to be flattish to down slightly for the full year. (07/14/2020, emphasis added)"

The banking industry is ripe for a re-think on its cadence of operational and investment spending--atomic level productivity. We think there is appeal in what could be termed "committed incrementalism," a strategy we have seen work well for other companies. Successfully executed, the payoff from small steady budgeted advances against cost-inflation would be higher profitability, greater performance reliability, and a superior cost of capital. Earnings growth achieved while dialing back risk and volatility would yield a virtuous interplay of rising dependability and falling capital costs. That's a productivity story for the ages.

Important Note: For discussion purposes only. No recommendations are offered nor can any be inferred. All investing carries risks, including risks of loss of capital. Consult personal advisors who understand individual tolerances for risk before taking any action.