Banks have been the biggest winners in the market’s ‘Trump rally’ ever since the surprising election outcome last month.
While some market observers have warned of bank stocks getting too far ahead of themselves, there is general optimism that banks’ fundamentals have vastly improved since the election.
One of the optimists is Richard Ramsden, managing director at Goldman Sachs. Post-election, Goldman Sachs experienced the biggest gain among the major banks, hitting an all-time high and contributing one-third of the rally in the Dow.
In “Exchanges at Goldman Sachs” last week, Ramsden joined Jake Siewert for a discussion on the outlook for the financial industry.
Higher rates, higher profits
The consensus is that rising rates would improve bank profits, and Ramsden does not disagree. “Banks benefit disproportionately from increases in interest rates, especially from this very low level,” he said. “Their deposit books become a lot more profitable in a rising rate environment.”
Higher interest rates are expected to improve profit margins as banks can lend at higher rates. “What [banks] start to see is a widening of net interest margins that leads to faster revenue growth. So the market has started to price that in.”
While history suggests there is reason to be wary of that logic since there is no clear-cut positive relationship between higher interest rates and banks’ profit margins, Ramsden remained bullish. “If interest rates go up let’s say 100 basis points, you know, the banking industry on average will pass half of that to their deposit clients, and they will keep half of it for themselves in the form of higher spread income,” he said.
Another reason behind the rally is increasing expectations of a change in banking regulation under Trump. “You could start to see changes in the regulatory framework,” Ramsden said. Dodd-Frank regulations have adversely affected bank profits, especially those mandating the use of bank assets to preserve liquidity. “I think the area that you’re going to see the greatest focus on is the amount of cash that is sitting idle on bank balance sheets.”
Smaller banks in particular have been struggling under the weight of regulations that increased their cost of compliance, and, quite interestingly, big banks have found a friend in Dodd Frank as it raises barriers to entry for competitors. Ramsden though was optimistic, predicting that the burden on smaller banks would soon ease. “The regulatory environment is likely to change, in particular for some of the smaller banking institutions,” he said.