The evolving COVID-19 pandemic has wrought havoc on the global economy and banks find themselves in the eye of the storm. Their funding lines have been disrupted, many of their customers will struggle to repay their debts and, as interest rates and customer transactional activity declines, their income will reduce.

Bank shares have been some of the worst performing stocks for the year to date. However, despite the uncertainty, we consider the indiscriminate selling of banking shares to have resulted in a number of compelling investment opportunities, particularly in some of the large American franchises. We explore four of the larger US banks, namely: Goldman Sachs, JPMorgan Chase, Citigroup and Wells Fargo.

The giants take shape
Up until the 1980s, many American states prohibited banks from operating across state lines. Relaxing these laws unleashed a wave of consolidation across the industry, halving the number of US banks over the two decades that followed.

The onset of the 2008 financial crisis stalled bank combination plans, as they became inwardly focussed on containing their own credit challenges. Bank failures, however, provided an opportunity for those that were stable to acquire large competitors. Some of these included JPMorgan Chase’s acquisitions of Bear Stearns and Washington Mutual, and Wells Fargo’s acquisition of Wachovia (the fourth largest bank holding company in the US at the time).

The top 10 banks in the US today control roughly two-thirds of industry assets, with the balance split across almost 5 000 other banks.

Goldman Sachs: going mainstream
Goldman Sachs has long been the pre-eminent investment bank, providing advice on the largest, most profitable corporate finance transactions. Yet, despite the glamour associated with the industry – particularly prior to 2008 – post-crisis shareholder returns have proven disappointing as regulatory actions that followed the crisis impeded profitability. In response, Goldman is broadening its service offering.

Without relinquishing their long-standing dominance in investment banking, Goldman is pivoting towards a more traditional banking model – less volatile retail and commercial banking, and a focus on growing the existing wealth and asset management businesses.

In 2016, Goldman launched “Marcus”, a digital deposit-taking and consumer lending business offering attractive savings rates to the general public (a sector they viewed with disdain just years before). This has proven successful in gathering retail deposits at far cheaper rates than the bank’s historic funding cost. Furthermore, the acquisition of United Capital, an advisory business targeting the wealthy (but by no means the top 1%), broadens Goldman’s wealth management services. They are also initiating transactional banking services to corporate clients and recently launched their first credit card offering in conjunction with Apple.

While in the early stages and with more than half the bank’s capital still tied up in its investment bank trading business¹, Goldman is yet to prove its ability to compete in these less familiar, highly competitive traditional banking markets. These are very big markets and Goldman is optimistic that by gaining a small share thereof, together with cost cutting initiatives, their return on capital should significantly improve.

JPMorgan Chase: outspending on technology
Both JPMorgan and Citigroup are full-service banks offering everything from vanilla lending and borrowing services to investment banking-related functions, such as underwriting initial public offerings.

Slick digital banking offerings matter more today than ever before and JPMorgan spends more than any other bank on information technology, racking up $11 billion in annual expenditure. This level of investment in the technology arms race makes one wonder whether smaller regional banks can compete in this digital age (despite their typically better local knowledge of small clients). The large national banks appear to be winning, with the top three – Bank of America, JPMorgan and Wells Fargo – gathering more than double the annual deposit inflows than the 20 largest regional banks.

This technology investment enables JPMorgan to better serve customers and generate industry-leading cost performance and returns on capital (charted below). JPMorgan has the second largest branch network in the US after Wells Fargo and, while branch numbers in the US continue to shrink in totality, they are one of the few banks rolling out branches (over 500 nationwide) to aid in capturing market share.

With the leading global investment banking and markets businesses, complemented by a large wealth management business, JPMorgan produces far greater non-interest revenue than competitors, which materially supports the bottom line in the current low interest rate environment.

Citigroup: credit card extraordinaire
Citigroup was the recipient of America’s biggest bank bailout during the financial crisis, requiring a government guarantee in excess of $300 billion to survive. Its prior poor credit underwriting performance continues to taint its share price rating today.

Citigroup’s loan book is three-quarters of the size of that of JPMorgan or Wells Fargo (each at $1 trillion). However, Citigroup offers the most diversified global exposure of the banks we discuss here, with a presence in roughly 100 countries – earning more than half of its revenues outside of the US. Over a third of Citigroup’s business is conducted in emerging markets, with a strong presence in Asia.

Citigroup issues a greater proportion of unsecured credit than its competitors. Although not the first to grant bank-issued credit cards (that honour belongs to Bank of America), they do have the second-largest card business in the US (after JPMorgan) and are the world’s largest credit card issuer. In addition to Citigroup-branded credit cards, private label cards for the likes of American Airlines and Shell are also issued.

Although Citigroup serves US retail clients nationwide via its mobile app and credit card offering, the bank has the smallest domestic branch footprint among the big US consumer banks. Branches are concentrated only in New York, Chicago, Miami, Washington DC, Los Angeles and San Francisco. A third of profits are generated by the consumer bank, with the balance generated by the institutional business. Notably, Citigroup has one of the larger investment banking operations and their bond-trading unit is ranked first in the world.

Wells Fargo: a bumpy ride
Wells’ stagecoach emblem dates back to the days when the company’s coaches traversed America delivering gold and packages. When the government nationalised the delivery service in 1918, Wells was forced to reinvent itself and grow its nascent banking service, which gradually extended into a full banking offering. Part of this transition was achieved through being a serial acquirer, mopping up well over 12 000 entities.

Wells is a leading retail and commercial bank, but with minimal exposure to investment banking. They are a US-focussed lender with an extensive branch network across the country (very few US banks have a national branch network), serving one in three American households. Compared to competitors, their loan book has a higher exposure to mortgages (originating up to a third of the country’s retail mortgages) and the bank has a high cost base. A drawback of the product mix is that Wells is more adversely impacted by low interest rates.

Just five years ago, Wells was vying for the title of ‘the world’s most valuable bank’, but today – after some material missteps – they are not even the highest valued US bank (currently claimed by JPMorgan). Part of their success stemmed from excelling at incentivizing employees to increase product penetration within their client base. However, ever-increasing sales targets led to staff opening fake accounts, mis-selling products and signing up customers for products without their consent. Theirs was an unfortunate fall from grace, for a bank that survived the financial crisis largely unscathed. Penalties imposed for these scandals prevent Wells from growing its balance sheet, consequently hampering profit growth and impeding their ability to respond to disruptive changes impacting the industry. It remains unclear as to when the penalty cap will be lifted.

Compelling long-term proposition
With the full extent of the economic impact of the COVID-19 pandemic and consequent containment measures still unknown, it is uncertain whether the banks’ reserves will be large enough to survive and protect the real economy. There is no doubt that this period will stretch the banking system to its limits – more than likely causing some to fail.

First quarter loan losses across the largest US banks (Bank of America in addition to those discussed here) are already up 3.5-fold compared to the first quarter of 2019 and exceed $25 billion (charted below). However, unprecedented monetary and fiscal actions by US authorities are containing some of the immediate risks and regulatory concessions will assist the banks in navigating the adverse economic environment. Additionally, banks provide less than 25% of corporate credit in the US and most higher-risk corporate credit does not sit on bank balance sheets.

Considering the above, it is clear that each of these large banks specialises in slightly different lines of business. Although it is impossible to be certain of the impending credit performance of any one particular bank amid this severe COVID-19 stress scenario, all of the above banks are well-capitalised, have strong franchises, benefit from enormous economies of scale, are gaining global market share from weaker European banks and typically generate high returns of capital for shareholders. Therefore, we believe that the basket of positions we have established across these counters at very low share prices will, in time, collectively generate attractive returns for our clients.

¹ Basically, buying and selling bonds, equities and derivatives on behalf of clients