While the US economy has made a steady expansion since the 2008 recession, some economic indicators have been flashing yellow, signaling the future may not be as bright. The warning signs were punctuated on July 31 and September 18, when the Federal Reserve cut its funds rate by 25 bps, each time citing “uncertainties in the outlook” and “risks to [the] positive outlook.”1 This reversal from 2018 policy has left many banks’ earnings under pressure—from threats to net interest income and the prospect of expense gaps opening in 2019 and 2020. Both factors may be exacerbated by potential future rate cuts.
Several developments could destabilize global growth and put a brake on the US expansion: slowing manufacturing and lower GDP growth in China; uncertainty over the form and consequences of Brexit; and gathering trade and tariff tensions, to name a few. While the financial system has been strengthened thanks to years of capital management, slowing growth and losses in certain asset classes could put significant pressure on banks’ bottom lines.
Near-term earning gaps
The Fed’s quarter-point reductions in interest rates in late July and September are expected to reduce banks’ net interest margin (NIM) and profitability due to differences in the pace of repricing of assets and liabilities. In addition, at low interest rate levels, further reductions will more significantly impact NIM due to an implicit floor for depositor interest rates and the cost of funds. While some European banks are experimenting with negative rates on their wealthiest clients’ cash deposits or with fees on cash that serve much the same purpose, the de facto floor for interest rates will approach zero for most US institutions.
Of course, banks will feel the pain of the Fed’s rate cut differently, based on their exposure to interest rate risk and degrees of maturity transformation. In the aggregate, however, early estimates see the US banking sector giving up about $8 billion in net interest income from the late July and September cuts, with a greater impact possible from further easing.2 Because of the NIM pressure—and as a result of efforts to prepare for credit losses in case of a downturn—some banks now have expense holes to fill in 2019 (3 to 4 percent of the expense base) that will only deepen in 2020 and 2021 (10 to 12 percent).
Long-term recession risk
The near-term earnings gap may only be a preview of challenges to come. While the onset of recessions is notoriously difficult to predict, several indicators have pointed to an increased likelihood of a downturn in the next 18 to 24 months. In this event, based on scenarios set out by several major sources, McKinsey estimates the impact could range between $117 billion in credit losses for US banks, and, in a worst-case scenario, potentially as high as $435 billion (Exhibit 1).
At the shallow end of the range for the estimated credit losses for US banks are downturns triggered by a slowdown in China’s growth ($117 billion), or a trade war ($141 billion).3 A moderate recession could bring $278 billion in credit losses.4 The high end of the estimate range, $435 billion, corresponds to a recession as severe as the 2019 Fed CCAR severely adverse scenario, and is presented to define an upper bound.
Banks can act now to shield their margins by prioritizing strategic investments
The expected reduction in banks’ net interest income, or the impact of a recession on credit quality, does not need to translate in a reduction of profits. We suggest that four actions can position banks to address the near-term gap while preparing for recession.
- Productivity program acceleration: First, banks need to improve efficiency ratios—through automation and digitization, procurement optimization, simplifying their organizations, network optimization, and streamlining commercial credit process. The resulting expense cuts and productivity improvement can be taken to the bottom line, to address earnings gaps and create cash reserves for priority investments. To inject a new perspective to existing productivity efforts, many institutions prefer to evaluate the full potential of their business using an investor-like due diligence approach. This approach challenges incremental thinking and typically uncovers both near- and long-term opportunities.
- IT modernization: Second, management teams should avoid the temptation to fund an earnings gap by paring back priority digital and IT modernization efforts. Digital “haves” command an advantage over “have nots,” especially during periods of low NIMs and recessions: These leaders have demonstrated a better knowledge of their customers, and stronger relationships through frictionless service at a lower cost. Importantly, they will also be able to avoid large-scale IT expenditures in hard times. The digital have-nots, in contrast, will likely have to cede further ground in downturn, and when they regain the capacity for investment, will have to run twice as fast to cover the strategic ground lost.
- Balance-sheet optimization: Third, banks should reorient their balance sheets, liquidating underperforming assets and emphasizing high-quality holdings that can provide liquidity and resilience in a range of scenarios including low interest rates and recessions. And where possible, banks should expand their sources of fee income that do not entail credit or interest rate risk.
- Analytics to mitigate risks: Fourth, banks need to use analytics to quickly identify and mitigate risks, given the credit losses possible in a recession. Leading banks are starting to apply analytics, often leveraging and enhancing existing CECL and CCAR models, as a basis for managerial and planning decisions. On the other hand, banks that currently use CECL and CCAR models only for accounting and regulatory purposes are ignoring a tool that can deepen their understanding of their portfolios and drivers of income and expense, as well as reduce losses if and when a recession hits.
The authors would like to thank Dogan Bilguvar, Arun Gundurao, Chetan Venkatesh, and Kirtiman; Pathak for their contributions to this piece.
1 Federal Reserve issues FOMC statement, July 31, 2019; Transcript of Chair Powell’s Press Conference Transcript September 18; federalreserve.gov.
2 This estimate uses as input the estimate of the impact of changes in interest rates on NIM found in Stijn Claessens, Nicholas Coleman, and Michael Donnelly, “‘Low-For-Long’ Interest Rates and Banks’ Interest Margins and Profitability: Cross-Country Evidence,” International Finance Discussion Papers 1197, Board of Governors of the Federal Reserve System, 2017.
3 The corresponding macroeconomic scenarios used as inputs in our models were sourced from Oxford Economics.
4 The moderate recession macroeconomic scenario used as input in our models was sourced from Moody’s Analytics.