“Too Big to Fail”—a term often mentioned in the context of financial crises, has once again been brought to mind while evaluating the current outlook on the financial industry. With the demise of Lehman Brothers and Bear Stearns in 2008, I was curious about which institutions could potentially contradict the belief that an organization is, indeed, too big to fail once again. To my surprise, banks are not failing this time, but flourishing.
With extensive fiscal policies during the pandemic seeking to encourage lending activities, the CET1 ratios (Tier 1 Ratio), a capital requirement metric used for financial institutions, have been closely monitored by the Feds through stress testing. Many were worried that the banks’ capital ratios would continue to decrease due to bad debt and loan expenses, eliminating the buffer effect banks maintain. This would induce additional gaps to meet further CET1 Ratio Requirements, putting the banks’ recuperation ability to the ultimate test. However, financial institutions have been mostly well-positioned in their health and have been able to overcome these short-term hurdles by leveraging their core businesses and focusing on strategic planning.
Goldman Sachs (GS) is a prime example. When the Fed conducted a stress test in June, it was one of the only banks that ran at a shortfall of the new capital rules. While cutting dividends and refraining from shareholder buybacks seems to be the best way to alleviate existing strain, Goldman Sachs instead amplified its shareholder activities. Goldman Sachs CEO David Solomon commented that GS had “a track record of rebuilding capital when necessary,” voicing confidence in the bank’s strength in resisting economic downturns.
When the time came, he 150-year-old bank once again proved its resilience. It brought its ratio back to 14.5 percent at the end of Q3, combined with $3.6 billion in net profits to crush Wall Street’s earning estimate. JP Morgan, Citi, and UBS were all among the A-team.
What contributed to those major bouncebacks? One of the most utilized strategies involves cost-cutting initiatives. Some of the solutions include business integration, digitization, divestiture, and even labour cutting and layoffs. Deutsche Bank, for instance, has been proposing a solution even prior to the pandemic, including an employee-slashing plan and potential Retail Branch and IT-Department closedowns. Credit Suisse, on the other hand, seeks to merge its trading and investment banking division, hoping to synergize its core businesses and bring down unnecessary barriers that prevent revenue maximization. A variety of restructuring efforts hint at the adaptability of financial institutions to the pandemic and signals their strength.
What’s more, investors may also look beyond the banks’ defensive mechanisms and focus on the lifelines and earning landscapes, in which performance and fee-based managements and trades are of particular significance.
One of the key ingredients of this recipe lies in the Global Markets and Asset Management Division. For GS, it consists of 68 percent of its business, but represented a whopping 73.2 percent of revenue in the third quarter. Within these distinctive divisions, equity trading and investments stand out. With a simulated stock market recovery, GS benefited from a public equities surge and implied volatility ahead of election. Debt, on the other hand, benefited from tighter GMBS yield and corporate credit spread, leading to a boost in bond trading and FICC product revenues. GS was able to effectively overshadow its provision for credit losses and operating expenses with these operations. Many other US banks reported similar feats.
On the other, largely ignored, side is the importance of private or consumer banking businesses which is utterly a win or lose situation, depending on the client landscape and geographical focus. For instance, UBS’s Wealth Management has most of its market share in North America, thus is resistant to currency fluctuations. On the other hand, Credit Suisse has been posting losses due to its global client focus. A depressed dollar in a low-interest rate setting might be great for domestic lendings, but difficult for foreign transactions; increased commission and associated fees could halt the potential upside.
Hence, the short-term triumph or earnings miss of banks is not a single factor game. Investors will have to assess the strength of each institution by understanding the focus of their businesses distinctively. If the bank does well enough in their specialty or refines a new mastery during the pandemic, it is likely to secure its reign, stay afloat, and even elevate its position amongst its peers. Luckily, we are seeing a collectively innovative, immune, and fast-adapting industry in the current state of the world.