David Ellison, a portfolio manager who specializes in bank stocks, started his investing career 36 years ago, around the time that Blockbuster Video was founded. One of his biggest worries is that America’s lenders will go the way of the erstwhile movie rental company that failed to keep up with technology.
“The thing I want to see them doing is trying new things,” said Ellison, a portfolio manager at Hennessy Funds, which oversees $4.8 billion in assets. “The top 10 or 20 banks, they have enough income to hire people, pay them enough money to make decisions, and try to move the bank in a direction that will not leave it like Blockbuster.”
The worry for US banks, as Ellison sees it, is that a core means of making money is faltering. Big lenders aren’t suddenly going obsolete like video-rental stores, but the profit they make from the spread between deposit rates and loan rates keeps getting skimpier. Ellison isn’t alone on this: stock market data shows that investors are increasingly worried that bank profits are set to suffer.
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Their worry is rooted in bond yields (or, more precisely, the lack thereof). It’s a malady that started in Japan, spread to Europe, and, the thinking goes, could become entrenched in the US. Fearing economic stagnation, or worse, central bankers in Tokyo, Frankfurt, and Washington have spent years driving bond yields lower in hopes of boosting their economies and creating jobs. Lower yields are meant to cut the cost for businesses to borrow, and to induce investors to take more risk and extend money to enterprising companies.
Mortgage interest rates tend to follow yields on government bonds: As the rates on US Treasuries decline, so too does the interest rate on home mortgages. Lower mortgage rates can also goose the economy, by making housing and other types of personal debt more affordable, thereby spurring consumers to buy more.
The problem for commercial banks is that government bond and mortgage interest rates keep going lower, but it isn’t as easy to cut deposit rates—the rate at which banks themselves borrow from customers—at the same pace. After all, it’s tough to convince people to keep deposits in an account that returns less than they put in (even though this already happens, invisibly, through inflation).
Depositors may try to switch to cash, or buy some other sort of asset (bonds, stocks, gold) to avoid taking a hit in their savings accounts, which makes banks reluctant to cut deposit rates below zero. That’s why the net interest margin, as the gap between long-term loan rates and short-term funding rates is known, keeps getting leaner.
This has pushed big banks to hunt for profits in other business lines. Top-tier lenders like Bank of America and JPMorgan are pouring billions of dollars into new technologies, while also ramping up efforts in less sexy but proven money-makers like cash management and payments. Goldman Sachs jumped into the consumer lending business in 2016 and has been busy snapping up stakes in fintech startups. The Wall Street bank has focused on things like personal loans, which carry relatively high yields of, in some cases, 20% or more.
In a low-rate environment, the bulge-bracket banks have it better than smaller lenders. The likes of Citigroup have diversified businesses that rake in billions from advising clients on mergers and acting as a broker for trading. Small community banks, meanwhile, can be almost entirely dependent on net interest margin.
Becoming more European
Interest rates have been dropping for decades, but the US economy, compared with Japan and Europe, has been more robust, translating into a better net interest margin for banks. This has probably been one, perhaps under-appreciated, reason why the big US institutions have outperformed their European counterparts over the past 10 years.
There are only a handful of big universal banks left—JPMorgan, Bank of America, Citigroup—and they are mainly based in the US. Royal Bank of Scotland once went toe-to-toe with Wall Street but has retreated since the crisis in 2008 and is still part-owned by the UK government. Germany’s Deutsche Bank has been humbled and given up on its global ambitions. That’s a big change from 2007, when RBS and Deutsche Bank were the first- and second-largest banks in the world, respectively, by assets. They are now 28th and 16th.
The big American banks have benefited from economic tailwinds in their home market, proximity to the world’s biggest asset managers, as well as higher interest rates that propel their net interest income. That extra profit gives them the resources to invest in becoming more competitive, which has seen them take market share in things like European investment banking from local rivals.
The outlook for European lenders isn’t great. “It’s not too promising at the moment when you get deposits at a zero rate and lend with something close to zero,” said Antti Saari, head of research at OP Corporate Bank in Helsinki. “You don’t get much in between that, especially when central banks charge banks for their extra deposits.”
Could the US become like Europe? In August, the yield on 30-year US Treasuries fell below 2% for the first time ever (its yield was double that just before the last recession). The Fed’s benchmark rate is only 2-2.25%, versus more than 5% before the last recession began. Some strategists worry that policymakers will quickly hit zero when they cut rates during the next downturn.
“The market is fearful that we are going to end up like Europe—margins are going to go down, earnings are going to go down, so why should we bother buying bank stocks?” said Ellison of Hennessy Funds. Mastercard, Visa, and PayPal were the top holdings in his large-cap financial company fund in June, followed by Bank of America. “The market tells you where they think value is and where they think you should be moving,” he said. “They want payment processors. They want that side of the business. They don’t want the lending side.”
Banks can find ways to compensate for thin lending margins by leaning on fee-based income, or dialing up the amount of risk they take, according to the Bank for International Settlements (pdf). A lot depends on how concentrated a country’s banking sector is, and the health of the overall economy. Research published last year by the IMF acknowledges that low interest rates have been a particular challenge for Europe’s lenders, and suggests that the region will need a smaller, more consolidated banking sector in order to adapt.
Free mortgages
To see where things could be headed, some investors are looking to Denmark.
The country’s central bank has imposed sub-zero interest rates since 2012—the longest of any country. This has rippled through the banking market: Jyske Bank, Denmark’s third-largest lender, offers a 10-year mortgage with a negative interest rate (-0.5%). The way it works is that the borrower’s debt outstanding is reduced by more than the amount paid each month.
In Denmark, banks typically issue a bond and pair it with the mortgage at the same maturity and interest rate. That means Jyske and other Danish banks aren’t looking to make money on the spread between the mortgage rate and the funding rate. Instead, the lender profits by charging fees, such as an upfront charge of around 20,000 Danish krona ($2,791) for mortgage borrowers.
“The income will be the same if the interest rate is plus 0.5 or minus 0.5,” said Jyske housing economist Mikkel Høegh.
Should American banks prepare for a future for without interest income? Probably not. The US economy has so far proven more dynamic than Europe’s, and its financial markets have offered perkier yields as a result. But as rates drift ever closer to zero, interest income doesn’t seem likely to offer attractive returns for banks in developed markets anytime soon. If stock prices are any indications, lenders must urgently come up with new ways to make money.
This is part of Quartz’s six-part field guide to the future of banking publishing this week, the rest of which is available exclusively for members. Support our journalism by becoming a member today, and get 50% off the annual cost of membership by using the code “banking” at checkout.