There’s a battle happening in the banking sector right now. Over the past few weeks, several investment advisors and pundits have touted bank stocks as a great investment to benefit on rising rates.
That advice hasn’t turned out so well, and it may get worse.
Banks like to keep their internal business as quiet as possible, but Monday morning, The Wall Street Journal blurted out the news that big banks biggest depositors are pulling out of low-yield accounts.
The banks are surely not thanking the Journal for spreading the word. The KBW Bank Index was already down 19% since late January. Then it got worse. The morning the news came out, major banks took further 2% to 3% hits.
Investors rightly understood that low-yield deposit accounts are like free money to banks. Losing those funds could noticeably crimp bank earnings in coming quarters.
The banks really didn’t want people to focus on this. Though Bank of America, Citigroup, and Wells Fargo saw a combined 5% drop in no-interest account balances, the Journal didn’t have a single banker’s quote in the lead story. Everyone in finance takes the Journal’s calls. That’s suspect. The info all came from public filings.
This was bound to happen eventually. For a while, as the Fed raised interest rates, banks were able to keep no-deposit accounts from fleeing to higher-interest alternatives. Rising rates even worked to their advantage last year. As Fed rates rose, banks charged customers more on loans and credit cards but didn’t raise the dividend to their depositors accordingly.
Now the game has ended. Money is flooding out. Banks are forced to offer higher yields to keep customers.
Overreacting to the Expected
The Fed has been raising interest rates for almost three years. The latest increase makes the eighth time. Advisors who said bank stocks were a good idea were partly correct. Bank stocks were already down. And in most cases, rising rates means more income from making loans. So why not jump back in?
The caveat is that consumers and business customers have to want to borrow.
It may not be the canary in the coal mine, but one area that is already showing weakness is home equity credit lending, which is down 8.7% from a year ago.
In the short term, the biggest threat to investors is not in bank stocks, however. Rising bond yields have a high potential to draw money out of equities. The Investment Company Institute (ICI), which tracks fund flows, reports that another $11.3 billion pulled out of mutual funds in the second week of October. That was the third week in a row of net outflows. That week, bond funds took a hit, too, but in the other weeks, bond funds had been seeing net inflows.
Banks Are Vulnerable, But Non-Banks Are In Bigger Trouble
The viability of banks as great investments is unclear. For instance, Citigroup and Keefe Bruyette & Woods downgraded Bank of New York Mellon. But S&P (CFRA) has reiterated its strong buy rating. It’s that way throughout the sector.
There’s another undercurrent in this story, however. When we talk about interest rates and banks, it is easy to forget that some of the biggest banks in the country aren’t banks. They are insurance companies.
Insurance companies are much more lightly regulated than banks are. Axios reporter Felix Salmon just dug into one case where this could mean trouble—for Prudential Insurance. Prudential stayed on the US Treasury’s “too big to [let] fail” list when other insurers like GE, MetCapital, and AIG were rated strong enough to come off. Prudential is off the list now, too, but it’s not safe to deem it safe on those grounds.
It’s not clear why the Treasury changed Prudential’s status. It could be simply size. Prudential is big, but at a market cap of $48 billion, it’s not one of the giants. US Bancorp ($85 billion), Citigroup ($168 billion) and Wells Fargo ($249 billion) are far larger. Salmon’s concern is that the insurance company is too close to the edge if it experiences a surge in life insurance claims. And if that happened, the troubles would accelerate as policyholders moved their insurance to other companies. Prudential is big enough for a fire-sale liquidation of assets in that scenario to burn the rest of the industry, too.
Elsewhere in the insurance universe, it’s property claims that are worrisome. Thanks to climate change, which some believe not to exist, we are experiencing more frequent high-damage hurricanes, flooding, and wildfires. In 2017, the insurance industry paid out $138 billion for such damages. That was the worst year ever for the industry. 2018 probably won’t beat that but it will another expensive year.
If the worries of reporters like Salmon seem overrated, the industry is just as jittery. PWC’s Audit and Risk Committee surveyed insurance company execs to find out what they believed would be the greatest challenges for 2018. They were worried about overregulation. Like every other industry. They were worried about handling technology changes, which also affects every other major industry.
But there was one thing the insurance company insider said that is not true for most industries: 44% think that most companies in the business now will not survive beyond another five or 10 years.
That’s a worry you can bank on.
“We don’t discuss the question anymore of, ‘Is there climate change,’” says Munich Re’s CEO Torsten Jeworrek. “For us, it’s a question now for our own underwriting.” Swiss Re had to retool its risk model for flooding and rain damage altogether because past results truly didn’t predict what has been happening recently.
And to end on a high note of worry… global warming (which isn’t real to some, of course) has increased the risk of a hurricane hitting the Persian Gulf and wiping out massive oil production facilities.
Compared to all that, banks seem pretty safe after all.