Tim Melvin recaps the week in Community Banking

Earnings season is pretty much behind us now, and the Federal Reserve issued its latest minutes. While Wall Street is celebrating the fact that a historically high number of companies exceed the estimates, they are ignoring the fact that earnings were down quarter year over year.

Expectations have been reduced so much that beating them was not all that difficult. I am pleased with what we saw from our small banks, and the yield curve steepening expect we will have a solid fourth quarter as well.

Thoughts on the Federal Reserve

The Fed has been busy this week. Last Friday, they released the Financial Stability Report that examines the stability of the US financial system and markets. They find that many assets are highly valued based on historic norms but that low-interest rates are part of the reason that multiples are high and the demand for stocks and investment-grade bonds are in line with the level of rates.

High yield bonds and leveraged loans don’t align with rates; however, increased risk exists in these markets. Commercial real estate is pricey based on historical norms when compared to cash flows produced by the properties while residential real estate is in line.

The Fed and Leverage Levels

The Fed also looked at leverage levels and found that “The banking sector is well-capitalized, in part due to the regulatory reforms enacted after the financial crisis. However, several large banks have announced plans to distribute capital to their shareholders in excess of expected earnings, implying that capital at those banks will decrease. In addition, the outlook for the profitability of a range of financial institutions has weakened. Leverage at hedge funds stands near the top of its range since 2014. Leverage at life insurance companies has also risen but remains close to its average level over the past two decades. Broker-dealers and property and casualty insurance companies continue to operate with historically low levels of leverage.”

So it would seem everyone is keeping their heads on their shoulders except for hedge funds and large banks. That should end well.

Borrowing is following a similar pattern. The report noted, “On balance, vulnerabilities arising from total private-sector credit are at moderate levels. Business debt levels are high compared with either business assets or GDP, with the riskiest firms accounting for most of the increase in debt in recent years. By contrast, household borrowing has advanced more slowly than economic activity and has been heavily concentrated among borrowers with high credit scores.”

The Federal Reserve on Systemic Risk

The most significant risks to the financial system noted by the Fed are from Trade policies and monetary policies. There as also some concern that a recession could reveal that some industries and companies hold too much leverage. heir collapse could spill over into eh broader economy. There are concerns about passive investing and ETFs causing a liquidity mismatch should we see a sell-off in the equity and high yield bond markets.

Federal Reserve Minutes for October

The Minutes of the October Fed meeting arrived without any real surprises. The Fed thinks that GDP will rise more slowly in the second half of the year than in the first half, mostly because of continued soft business investment and slower increases in government spending. The minutes noted that “Participants generally viewed the economic outlook as positive. Participants judged that sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective were the most likely outcomes, and they indicated that their views on these outcomes had changed little since the September meeting. Uncertainties associated with trade tensions as well as geopolitical risks had eased somewhat, though they remained elevated. In addition, inflation pressures remained muted. The risk that a global growth slowdown would further weigh on the domestic economy remained prominent.”

There were no surprises in any of that, and it is consistent with my expectations. If the fed and I prove correct and we just grind away with low growth for an extended period of time ou small bank stocks should continue to do well. Low growth should also continue to drive M&A activity.

Mobile Banking and Tech

The drive for mobility in banking has accelerated. According to a recent report from MX, a banking data company, 86% of us use online or mobile banking as opposed to going into a branch. That can be tough for the smaller banks as matching big banks in tech offerings is outside their ability and budget.

The bigger problem is that it is not just bigger banks but big tech that is trying to compete. 50% of us would open a checking account with Apple (AAPL) or Google (GOOGL) if they had FDIC insurance.

The same percentage would borrow money from a big tech firm. Amazon had explored offering a checking account. However, the firm stepped back when it became evident that the regulatory hurdles were too high. They won’t stay away forever, and that’s going to be a huge problem for smaller banks.

Fintech and BigTech

René Stulz Of Ohio State University recently published a paper titled “FinTech, BigTech, and the Future of Banks” that looked at this problem. The paper found that “Banks are unique in that they combine the production of liquid claims with loans.

They can replicate most of what FinTech firms can do, but FinTech firms benefit from an uneven playing field in that they are less regulated than banks. The uneven playing field enables non-bank FinTech firms to challenge banks for specific products whose success doesn’t link to what makes banks unique, but they cannot replace banks as such.

In contrast, BigTech firms have unique advantages that banks cannot easily replicate and therefore present a much stronger challenge to established banks in consumer finance and loans to small firms. Both Fintech and BigTech are contributing to a secular trend of banks losing their comparative advantage as they have less access to unique information about parties seeking credit.”

Competing with JP Morgan (JPM) is tough enough for a five-branch bank with a couple of hundred million in assets. Competing with JP Morgan and Apple, Amazon (AMZN), Facebook (FB), Google, and Microsoft (MSFT) is going to be damn near impossible. At some point, this becomes another driver of M&A activity.

By: Tim Melvin

Related: Big Reveal by Dallas Fed President: Fed “Actively Looking at and Debating” a Digital Currency