THE HEALTH of the US economy and that of its banks are closely linked. Sometimes, as during the global financial crisis of 2007-09, the risky behavior of banks leads to the downfall of the entire economy. But even when, like today, the banks aren’t the root of the country’s economic woes, their vital signs still tell you about the big picture – about the ability of individuals and businesses to repay their debts, their willingness to borrow and the appetite of companies to raise capital on public markets. The third quarter banking earnings season, which begins October 13, is the next opportunity to take the pulse of banks and assess how the U.S. economy is recovering from the ravages of covid-19.

The economic turmoil caused by the coronavirus has cut both tracks for banks. Commercial banking (primarily the business of receiving deposits and loans) has suffered from the collapse of the economy, but investment banking has flourished. As markets swayed when the pandemic took hold, investment bank trading volumes soared, for in volatility lies the possibility of profit. In the second quarter, trading revenues of the largest banks hit a record $ 26.9 billion, up 70% year on year.

Bank bosses have expressed doubts about the continuation of this windfall in the third quarter. But the astonishing race in tech stocks and the boom in public equity offerings it fueled likely kept the money men busy over the summer. Morgan Stanley and Goldman Sachs, the two big banks that derive most of their income from investment banking, may not repeat the second quarter explosion, but are still expected to report growing revenues and stable profits at the third. (While both have done well with investment banking this year, they’ve been trying for the past few years to reduce their reliance on it – Goldman by starting a retail bank, Morgan Stanley by stepping up in asset management. On October 8, Morgan Stanley said it was buying Eaton Vance, an asset manager, for around $ 7 billion in cash and stocks.)

The good performance of investment banks has so far helped offset the damage caused by the real economy. In the first two quarters of 2020, the four largest US lenders wrote down the value of their assets by $ 50 billion as they made provisions for expected losses on loans. Bank of America, Citigroup, and JPMorgan Chase, which have big investment banks as well as giant commercial banks, found themselves profitable. At Wells Fargo, which does not have one, and other smaller banks, these write-downs resulted in losses in the second quarter.

The question now is whether actual loan losses will exceed these allowances or turn out to be less gloomy than what the banks have braced for. In the past, declining bank profits, partly reflecting provisions for bad debt, tended to be followed by the worst loan losses (see chart).

So far, no significant losses have been recorded, in part due to official measures to support the economy. Cash was distributed to businesses through the Paycheck Protection Program (PPP). Households received payments of up to $ 3,400 and unemployment insurance was increased by $ 600 per week. The Federal Reserve kept its policy very flexible (which also boosted the stock market). Write-offs, that is, write-offs of defaulted loans, among the four largest lenders rose 22% year-on-year in the second quarter, but still stood at just $ 4.9 billion. The same was true for overdue loans (those over 30 days overdue) and industry-wide write-offs, which barely increased in the second quarter.

Whether defaults will increase more strongly depends on several factors. One is the course of the economy. Most states have started to reopen, allowing businesses to generate more revenue than they were during the tighter isolation phase in early 2020. If the recovery continues, they are more likely to pay off their debts ; if it stalls, they are more likely to fail.

The other is the prospect of further economic stimulus from the federal government. The effects of the measures that kept consumers and businesses afloat through the summer will have faded in the third quarter. Five in six PPP borrowers said they had spent their entire loan at the end of August. Additional unemployment benefits expired at the end of July. Democrats and Republicans in Congress have yet to agree on a second support plan. If they ever do, it could prevent some anticipated losses from materializing.

If the losses turn out to be smaller than expected, banks, which already hold $ 2 billion in equity, could end up with much more – and much more than they need to meet regulatory requirements. But with the memories of 2007-09 still raw, the Fed wants them to keep their shocks well padded. On September 30, the central bank said the 33 banks with more than $ 100 billion in total assets would remain banned from repurchasing shares in the fourth quarter. Unlike European banks, they continue to pay dividends, but these will be capped at a level based on recent income.

Additional capital and the return of buybacks would be good news for bank shareholders, which were beaten in 2020. Even though the S&P 500 hit all-time highs throughout the summer, bank stocks remained poor. loved. The KBW index, which contains a selection of the major listed banks, is worth 30% less than at the start of the year.

Banks pay money, but to the authorities. This week two will bring back the cost of regulatory infractions. On September 29, JPMorgan Chase agreed to pay nearly $ 1 billion to settle allegations of “identity theft”: market manipulation through fake transactions. Then, on October 7, Citigroup was fined $ 400 million for failing to correct flaws in its risk management system. These follow a $ 3 billion fine paid by Wells Fargo to settle its fake accounts scandal in February and a $ 3.9 billion settlement between Goldman Sachs and Malaysia in July for the role of the bank in the fraud of 1MDB, an investment vehicle. No more of that, and bank stocks will surely remain unloved.

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