In 2019, the KBW Banks index which tracks US bank shares, has bested the return of the overall market. The index had previously lagged the S&P since the end of 2017 but 2019 has seen it return 33% compared to the 29% gain for the S&P.

What is really driving these gains though and is there actually a case for optimism for banks shares after a decade of so much heartache?

Source: Bloomberg

The sector has underperformed the market for the past 10 years, as most sectors did since it was tough to keep up with the fantastic tech rally. The KBW index returned 211% as opposed to 251% for the S&P on a total return basis (I used the ETF’s SPY and XLF as my comparables for these stats). However this was after the outsized returns that banks saw before the crisis and we all know what type of behavior was fueling that rally. Big banks in particular spent much of the time post crisis dealing with the barbs of public ire, regulatory oversight, digesting large acquisitions and cleaning up their balance sheet. None of these are helpful in their job to make money for shareholders.

US Banks Turn Emerging Market Like

A funny thing happened after the dust settled from the crisis though, large banks were forced or voluntarily absorbed so many other names that the largest have started to control an ever larger slice of the US banking pie. Below you will see that the 4 largest banks control about 36% of all banking assets in the US.

Source: ILSR

Other giant banks, which ILSR defines as those with $100 billion in assets or more, comprise of about another 25 banks, some of which are other large foreign banks or regional banks like the newly formed Truist Bank which is the post merger name of the SunTrust and BB&T union. This oligopoly in banking shares is similar to many emerging markets where a few banks dominate the market for banking assets and therefore are able to relegate many of the smaller banks to a second tier status. Take a look at how a few bing banks dominate India and Brazil.

India

Source: deal4loans.com

SBI being the State Bank of India. We don’t have a large state owned bank like some emerging countries, which tend to have a large market share and a mission to bank the masses but other private firms still hold a commanding market share. The case is similar in Brazil.

Brazil

Source: insights.invyo.io

In Brazil the top 3 banks make up 64% of the total sector. It’s tough for smaller banks to compete on this scale for wholesale funding and for customers. Smaller banks are usually relegated to a niche that the larger banks don’t want to touch. The large names take the best customers and the highest margin business for themselves.

The Future is Looking Bright

There is reason to believe that this could indeed be happening already in the US. Each large bank has its particular strength that it is doing its best to exploit but they are flexing their market power in doing so. For example Citi is the most international of the large banks. Due to their subsidiaries and branches in foreign countries, they are able to be the financial middle man for large corporations that need to ship goods all over the world and depend on international supply chains. AI is making the job even easier for them and when you have a $1.8 trillion dollar balance sheet, there simply aren’t many banks worldwide that can outspend you. The economies of scale allow investments that can automate certain manual processes that other banks just will not be able to match.

With that example in mind, I would like to go through each of the top 4 US banks and make the case for why each of them has a strong case to be able to pull away from their smaller bank competition and gain even more market share.

1. JP Morgan – The largest US bank by assets, JPM was one of the clear winners from the crisis. Consistent leadership under Jamie Dimon, avoiding bad loans that weighed on their balance sheet, as well as the move to absorb Bear Stearns made JPM much stronger post crisis than they were going in. Consumer and community banking make up 46% of revenue and the investment bank makes up another 34%. The investment bank is where scale and market perception give banks this size an edge. Market making and its name brand offer an advantage with corporate clients looking to tap markets. An $11 billion tech spend enables the firm to hold sway in the fintech space and make sure it keeps ahead of smaller rivals. The bank made $30 billion in net income in 2018 and planned to return $40 billion to shareholders starting last July. With a market cap of $436 billion, this essentially offers a combined dividend and buyback yield of 9.2%, in essence they are giving all the earnings and more back to shareholders while still investing heavily in the future. Giving so much back while still investing is a high bar to set for smaller institutions.
2. Bank of America – Swallowing up Countrywide and Merrill Lynch almost sunk BofA but it has managed to finally shed its bad assets and absorb the networks of these firms to gain the advantages of scale. As opposed to JP Morgan, the firm is a much larger wealth manager and lacks any asset management, which may be a good thing as asset management has gotten particularly competitive and wealth management has better margins. It also shed much of its international presence during the post crisis clean up which makes it heavily US focused compared to some of its peers. Although the retail network is smaller in number than JP Morgan, it is more balanced across the country. Combining this with its more banking for the masses approach, helps it use its scale to grab business from customers that others can’t. The share buybacks don’t hurt either, in July the bank announced $37 billion in buybacks and dividends after a 2018 that saw $26.7 billion in net income. The wealth management and consumer banking combination offers BofA’s advantage as it is able to bank middle class as well as wealthy customers front to back.
3. Citi – Citi is unique as the one US bank with a truly international presence. They operate in 160 different countries and have significant presence in emerging markets in Asia and Latin America. The bank has over 100 million customers outside of the US. This makes the bank uniquely positioned to benefit from a falling dollar and growth in emerging markets. Although the US stock market is providing much of the earnings growth globally, the rest of the world will not be stagnant for long and Citi plans to benefit from any pickup outside the US. The bank earned $16.7 billion in 2018 but the capital return plan disappointed a bit as it fell to $21.5 billion from $22 billion in 2018. With a P/E ratio of 10.59, the bank is a bit below its peers in terms of valuation so there is some potential upside here, especially if things get rosier internationally in 2020. The drawback to Citi is that their US presence is highly concentrated in a few big cities such as New York and LA, this means there is some concentration risk in this name on the funding side. At $1.9 trillion in assets though, the scale allows them to compete globally as well as domestically and Citi has carved out a strong branded credit card niche in the US.
4. Wells Fargo – Wells Fargo used to be more of a Western US focused bank until the crisis when it snapped up Wachovia, which was an East Coast focused bank headquartered in Charlotte. This enabled it to gain a balanced retail presence similar to BofA. It also tends to be very US centric, also similar to BofA. The difference here being that the wealth management unit is not as large as that of its peer but still is ranked 5th in the US with $564 billion assets under management. The firm announced a capital return plan of $31.4 billion last July which benefits investors but Wells is a bit hampered in the short run due to scandal. In 2016, It was revealed Wells had created fake accounts to cross sell to customers and was charging them for products they didn’t ask for. It led to the resignation of them CEO John Stumpf as well as the Fed placing a size restriction on the bank capping its assets at $1.952 trillion. This cap is still in place until at least the end of 2019 which limits the growth opportunities in the near term. Despite this, in the longer run there are still growth opportunities in expanding their deposit sources throughout the US and the footprint advantage to reach customers others can’t. They can offer a front to back experience for retail and corporate customers similar to their closest competition.

It’s worth mentioning the next 2 banks in terms of size: Goldman Sachs and Morgan Stanley. These banks each have around $900 billion in assets which I believe keeps them competitive in the top tier as the next largest bank US Bancorp is roughly half their size at $475 billion. Goldman is working on its transition to a universal bank since it’s conversion to a bank holding company during the crisis. They have rolled out their online bank Marcus to try and catch up to the brick and mortar competition. Morgan Stanley on the other hand, has pivoted the firm towards wealth management and they rank second after BofA in the US in this respect. Although Goldman and Morgan Stanley are old competitors, I see their long term strategies diverging significantly as their profiles continue to change.

Outlook

A few names mentioned above are highly dependent on US consumers, a downturn in 2020 could impact their earnings significantly but their scale enables them to have a leg up on smaller competitors. Tech spending, automation, AI, a full service offering to customers and overseas capability will ensure that these names don’t get displaced by an upstart be it a fintech, smaller bank or foreign competitor trying to move into the US. Banks with a large market share have a tendency to maintain that dominance over a long period of time as well. Those pie charts of Indian and Brazilian banking assets likely looked very similar 20 or even 30 years ago. The number of banks in the US has fallen by 34% since 2006 and we likely won’t see a reversal towards more banks any time soon, rather I am predicting further consolidation.

Even if there is a downturn, we likely won’t see the financial chaos we saw 10 years ago. Capital is much stronger than pre-crisis, they have access to low cost capital markets worldwide and the regulators have more or less (as far as we know) kept the banks out of questionable business due to their tight oversight during the past 10 years.

Even if consumer growth sags, banks will be able to use their lending capacity to strong arm corporate customers to tie in non lending revenue such as capital markets and advisory business. This is why you see the big banks so active with those Silicon Valley names, they have the balance sheet to carry them along to their IPO then will be set to take large profits on the float of shares. Smaller banks will have a difficult time matching these capabilities. For these reasons and the unique profiles of the largest banks, after many years of frustration, I am bullish once again on big banks.

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