Magic Markets #208: Banking on banking

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The Finance Ghost: Welcome to episode 208 of Magic Markets. This comes fresh after the inauguration of President Trump in the US, which was all the rage obviously earlier this week, not least of all because the US Markets were also closed on the same day. So, the only thing you could really read about or see was meme coins and Zuckerberg getting himself into all kinds of trouble with the Mrs and all that type of thing.

Moe, today we’re going to talk about banking, and that’s because we’ve covered JPMorgan in our premium show this week. Maybe before we do that, isn’t it interesting that the lineup of billionaires at the inauguration had pretty much nothing to do with banking? Jamie Dimon’s too important for that, in our view at least. It was all the techies, but not Satya Nadella, who’s out there busy creating shareholder value for Microsoft shareholders like me! “In Satya We Trust” is a joke we commonly make. Our show on JPMorgan this week is called “In Jamie We Trust” and neither of them were wasting their time at the inauguration. So I feel good about that.

 

Mohammed Nalla: You can feel good about it, Ghost. I was wasting my time watching the inauguration. I wouldn’t say end to end…

 

The Finance Ghost: No, I didn’t do that. I just waited for the social media spoilers and GIFs and memes – it’s just easier.

 

Mohammed Nalla: Social media is great because it curates all the great and very important content, like Mark Zuckerberg ogling Jeff Bezos’ wife – we’ll leave that one aside! I also love this meme where we had a frame where you had Elon Musk, we had Jeff Bezos, you had Zuckerberg, and you had Sundar Pichai from Google and a lot of people saying Sundar Pichai is the poorest guy in this picture – and he’s only worth $1.6 billion!

Bernie Sanders has certainly voiced certain concerns around the oligarchy in the United States. The oligarchy was on firm display at yesterday’s inauguration. It’ll be interesting to see what that heralds and means for this incoming administration. We also saw, more important than the pomp and ceremony around the inauguration, Trump signing a whole host of executive orders.

I think that’s important. Pay attention to that because that introduces a little bit of policy uncertainty. The markets are concerned about tariffs coming on Mexico and Canada. That certainly impacts me from February onwards. I think this administration will be one where you’ve got to pay very close attention.

Perhaps your strategy is the right one: pay attention to social media, because you’ve got a president who’s very prevalent on social media. That might be the first place where you see the news flow break, maybe even before a Bloomberg terminal Ghost. But that’s not what we’re talking about.

You indicated how Jamie Dimon wasn’t at the inauguration. Maybe he’s too important to be there. I don’t know. He was someone who said he wouldn’t accept the Treasury Secretary job. But it’s important that we’re discussing banking because I think where we are in the economic cycle, certainly with this US exceptionalism, is the fact that interest rates are coming down, but maybe not coming down to where we had seen them a couple of years ago, certainly during the crises and the pandemic. That bodes well for banking as an industry as a whole.

I’m going to use that to start off because we’re going to discuss on the show some of the key indicators you’re looking at when assessing a bank. You’ve obviously got to look at both macro as well as micro indicators. I’ll start off with some of the macro indicators and then hand over to you for some of the micro stuff. And the first one I’ve mentioned already: interest rates. When you’re looking at interest rates, remember, banks are effectively just earning a spread. They get deposits in, they pay you a certain rate, they then charge a spread on top of that, then they lend that money out and that’s what you’re looking for.

Traditionally, in an interest rate cycle, if you map that against banks’ operational performance, banks tend to do well when interest rates go up, certainly not to very elevated levels. At that point in time, you start getting concerned around credit losses and non-performing loans. But if rates have gone up to a level that the market can tolerate, that’s the sweet spot where banks make a lot of money.

I think we’ve seen that, certainly across the industry you’ve seen a very strong performance come through for a lot of those US banks. But what does that mean as the cycle turns?

We’re seeing the cycle turn now, you’re seeing rates maybe moving down. That is a double-edged sword. I want to highlight this because lower interest rates means that banks may be make a little less money on the interest that they’re actually earning from the loans that they’re lending out there.

It also has a positive impact in terms of overall credit demand because if you have lower interest rates, it stands to reason that people will be first of all considering buying houses. You’ve got to look at the long end of the yield curve there. What’s happening with the 30 year in the US? It’s usually the 30 year that impacts the mortgage rates. But then there’s also revolving credit, what you’re getting on credit cards, the willingness to go out there and buy cars etc. So, pay attention to where we are in the interest rate cycle.

Lower rates are not in and of themselves bad for banks in aggregate if they get the uptick in terms of credit demand to partially offset the drag from a slightly lower spread linked to interest rates.

You’ve got inflation. Obviously, interest rates are a function of what’s happening with inflation. I’m not going to explain that. If inflation is running hot, rates stay higher. If inflation’s actually cooling off, rates have the scope to go slightly lower. Then you’ve got to pay attention to the jobs metrics that we discussed the last time around.

Unemployment, what are people actually earning? You’ve got to look at personal spending, personal earnings data in the US and you get all of this macro data that really helps inform the outlook for the US consumer.

And then I’m gonna end off on what’s happening in the housing market, because this may have been the one area where the US market lagged. It’s because whilst you see the short end of the yield curve move around with policy rates, the long end has actually remained quite anchored. At this point in time, you’re actually seeing what they call yield curve steepness come back in. That can either be because short-end rates are going down or it could be because long-end rates are going up. In the US, it’s actually swung around. It’s now the long-end rates that are looking stickier and the reason for that is uncertainty around inflation. There’s uncertainty around what impact tariffs might have on inflation. Coupled with the US fiscal debt woes, that is keeping the long-end of the yield curve slightly elevated.

Now, why is that important? If that end of the yield curve stays elevated, it might just choke off any growth that you would expect to see from an uptick in the housing market.

That’s a quick wrap on some of the macro indicators. I know you’re gonna go into some of the more micro indicators, what you’re looking at when you’re looking at banks, balance sheets and their operations, so I’m happy to hand over now and I’ll come back in a little bit later.

 

The Finance Ghost: Yeah, those macro indicators that you look at in the US are the same in South Africa. Effectively it’s the same stuff that drives banks. What I will say is that South African banks are a lot more traditional. They are very much lending institutions. Yes, they have investment banking and we both have a background in markets and investment banking and advisory and structuring and all of that genuinely very cool stuff. If you’ve ever wondered about having a career in that, it’s time well spent in my opinion!

But there’s much less of that in the South African banks than on Wall Street. And when you look at the likes of JPMorgan, certainly let’s do Goldman Sachs, which is the best example of that and probably the most famous investment banking name of them all. It’s not exactly all they do. All of these banks have tried to build up more annuitised revenue streams because, unfortunately, advisory work is very lumpy in nature and extremely reliant on the level of activity in the market.

Then again, so are the traditional banking type operations as you’ve indicated there. If people are borrowing money to buy houses, then there’s more activity. If they are not, then there is less activity. That’s the point with banks – you are buying economic activity and a bunch of smart people who are hopefully taking capital and applying it in the right places for that economic activity. If you’re going to buy a bank in a country where economic activity is not great, you are probably not going to have a fantastic time. You will often see these banks trading at relatively high dividend yields. The South African banks are the perfect example. Go and chart them over any kind of reasonable period and it doesn’t look good. The fact that they had a pretty good year last year was really just a function of an uptick in sentiment and better equity values all around and some belief that South Africa is coming right. But it’s really just a very good year after a very bad decade and it doesn’t fix the underlying problem, it really doesn’t.

I’ve done the maths before. Go and look at it. You had to basically pick Capitec and hold it for a long time, resisting all temptation to sell it, just to match the returns in dollars that you’re getting from the best of the US banks. So, you basically had to pick South Africa’s very best post-democracy business story and then hold it vs. actually just buying any of the big names in the US.

It’s not easy from that perspective. If you’re buying banking, you’re buying an economy and I think that’s very important.

Then, when you drill down into the bank, then you start looking at stuff like the impairment ratios and NII and net interest margin, which is a very important one, and non-interest revenue, which is also very important. That’s a huge driver of return on equity. We can dive into some of that stuff now. But I just wanted to land that point that you’re buying the economic activity, right? I mean that’s, that’s the view you have to take.

 

Mohammed Nalla: Undoubtedly. Banks don’t operate in a vacuum. You want to see banks that are operating in regions that are growing, because when regions are growing, there’s demand for credit. That means that banks actually have a reason to operate and they make money on lending out. They also make money on economic or market activity. As you indicated, the two material parts here.

One is the interest income or NII, the other is NIR, the fee-generated income – a lot of that sitting in the investment banking side of things. The US has been exceptional in that they’ve had both of those. They’ve had the underlying economic activity, but they’ve had massive activity in capital markets as well. So really the purple patch, I guess, in terms of the overall macro outlook. If that continues, if you actually see economic activity remaining fairly robust, if you actually see market activity correlating with that and remaining robust, banks are primed to earn a lot of money in that value chain.

Ghost, before I hand back to you, I just want to indicate a very important point. When you and I think of our balance sheet, you look at any loans you have, that goes on the liability side because you’re effectively borrowing the money. The loan is on your liability side with a bank. When you read anything on a bank, remember that the bank is the one giving the loans and so those loans show up in the bank’s assets. Then, they show the deposits that they’re getting from depositors, from investors that are out there, on the bank’s liability side of the balance sheet.

That’s very important, just to contextualise that properly in your head, is that the bank is directly the opposite way around from the way you would view anyone else’s balance sheet, either a business or a person. That then obviously ties into some of the metrics that you’re going to discuss shortly.

 

The Finance Ghost: Yeah, absolutely. When they talk about loans and advances, what they’re really talking about is money they’ve managed to deploy into risk assets for the bank, which basically means taking on a loan from the bank and now being the bank’s credit risk. They are taking you on as a risk-weighted asset. They are doing a whole lot of balance sheet calculations around what that means for them and how they need to price your risk.

If they get that wrong, and we’ve seen it before, including in South Africa, sometimes a bank just gets an entire asset class wrong. Now, we don’t even need to go into the US banks and sub-prime and ‘08 and the Global Financial Crisis. That was obviously just the whole mess around mortgages, but there was also a lot of just underlying fraud there and repackaging of stuff and nonsense.

You don’t need fraud for a bank to get it wrong! You just need things to go wrong. If they misprice the risk and they’re too deep in, say, home loans, for example, and that sometimes – or not sometimes – that is why mortgage brokers exist, by the way, is because sometimes a bank just says, we are pulling back on mortgages, that’s it we are done. Even if decent business walks through the door, we’ve got too much mortgage exposure. Slow down the number of bonds you are granting. That’s why these mortgage brokers take you to all the banks, because for every bank that’s slowing down on that, another bank is looking at it and saying, okay, we don’t have enough exposure to this. We’re happy to then get more. We’ve got too much vehicle finance exposure or personal loans exposure. Then that’s the bank that’s giving out mortgages at the moment and using it as a way to maybe win some transactional account customers as well.

It’s all very interesting how that all works and it pretty much it all comes down to how banks work out their balance sheet metrics. It’s all highly, highly regulated. It’s the whole Basel regulatory regime. It all comes down to risk-weighted assets and how you work out equity ratios and all that kind of thing.

At the end of the day, it’s about how much capital the bank needs to hold against different types of business. Changes to these rules can shut down entire parts of a bank. So, for example, in Moe’s time and mine, in our careers in banking, you saw the shutting down of proprietary trading equity desks in South African banks. They were just shut down, they’re gone. All that activity basically moved across to hedge funds. It came in the wake of banking regulatory changes after the global financial crisis and how expensive it was to hold capital against those books as opposed to just traditional banking activities.

That’s really what’s driving a huge portion of the returns that you’re going to see from a bank. And that is what drives return on equity as well, which is the key metric when you are valuing a bank. It’s basically, with all said and done, what return can they generate against the equity that they are required to hold onto? If regulators say, hey, there’s too much risk in the markets, we need banks to hold onto more equity, then effectively ROE will probably diminish because that doesn’t necessarily mean that the banks are getting a better return, it just means they have to take less risk effectively. And that’s not good for bank shareholders. But it might be a good thing for the country as a whole, because the regulators care about systemic risk. Moe, they don’t care about shareholder returns, do they?

 

Mohammed Nalla: Ghost, you’ve just made the point that I’ve been jumping up and down to try and make, which is that the regulators are just really concerned around the health of the financial system. They want to make sure no banks actually roll over or fall over when you have a crisis moment. So they design regulations that are intended to stabilise the market and reduce volatility. That’s what we saw when banks had to shut down their proprietary trading desks, you actually saw a de-risking of banks. Yes, that has a material bearing on how banks go about making money, as well as the extent of money they make, but it also decreases the volatility because remember when banks had prop trading desks, you had a lot of volatility in the earnings. Whilst ROEs might have been fantastic in one year, they might be absolutely dismal in another year. You’ve seen a lot of that activity actually change.

Something very interesting along those lines, I actually read an article over the course of the last week which indicated that the rise of primary dealers, those are people that effectively go and market-make US debt / US sovereign debt / Treasuries, that’s actually stabilised and there’s less interest from market participants to be primary dealers because the US treasury is issuing so much more paper out there. That’s showing you a bit of a shifting dynamic. These banks have made a lot of money in their capital markets business, but it’s showing you that other market participants are saying it’s not lucrative enough for us to get involved. You could read that as both a positive and a negative.

That’s really the interplay between regulation market conditions and how the banks seek to extract value from the value chain.

 

The Finance Ghost: And of course, the other big regulatory thing that affects banks – you’ve already talked about Moe, it’s a macro point – is interest rates. All you need to do is have a look at banking earnings at different points in the interest rate cycle. If the pandemic gave us anything good in this world, and maybe working from home is one of them, although that seems to have largely gone away for most people so that one didn’t stick – but the lesson that did stick from the pandemic was it gave people a crash course, I suppose, pun intended, in what interest rates do in a market. Right? Interest rates suddenly went all the way down and it did crazy things to equity values, crazy things to banking earnings. And then they went up almost just as fast as they went down to try and like slow down this impact of inflation.

So you could see in banking earnings exactly what that does and how the banks were commenting on it, etc. I remember looking at South African banking earnings last year, I can’t remember exactly which bank it was, but it doesn’t really matter. They basically said, we’re kind of at the point now where more interest rate increases might have a slightly net positive impact on our business, but we’re kind of at the point now where credit loss ratios would start to offset the additional net interest margin. Rates have got to be at a fairly high level to actually get to that point.

Up until that level, interest rate increases are great news for banks for a very simple reason. Just think about your own life. When the interest rates go up, does your bond get more expensive? Yes. If your vehicle finance is linked to prime, does that get more expensive? Yes. Do you get paid more on your current account? Definitely not. Do you always get paid 1% more on your notice deposit because rates went up 1%? Probably not. The bank is always locking in a little bit more margin as rates go up.

The other big thing is they are lending out their equity. If you’ve got a huge equity balance, which remember you’re being forced to keep by regulators, lending that out at 10% is very, very, very different to lending that out at, say, 8%, for example. That 200 basis points on your equity is called the endowment effect. It’s a huge source of revenue for a bank. And remember, there are no expenses attached to it. They’re not borrowing that money from anyone. They don’t suddenly have more overheads; they’re just earning more.

So as rates come down, they start to earn less. On the endowment effect, it goes against you. And yes, the credit loss ratio may improve, but it generally doesn’t improve enough to offset the impact of dropping interest rates. We see this now in JPMorgan that we covered this week, where net interest income, the NII, has gone the wrong way year-on-year because of the effect of interest rates. They expect it to be down for the first half of 2025 and then only start to pick up as growth actually comes through. Keep that in mind when you look at South African banks as well.

In 2025, the SARB is still guiding for a decrease in rates. Moe, you’ll probably know better than me whether or not that’s going to happen, and you’ll have your macro expertise on that. But we’re probably going to get some more rate decreases, I certainly hope. It’s probably not going to be net positive for the banks, even if it drives some growth. I think this year is not going to do great things for South African banking earnings.

 

Mohammed Nalla: I think the important point to also note is the absolute level of where interest rates are. I was doing some sums on a deal down in South Africa recently, and when you have to start doing your sums at, let’s call it close on 10%, I guess that’s where prime is right now, there and thereabouts, it’s very different to doing your sums based on rates up in the developed world. So if you were to see, for example, from the US Fed, two more cuts of 25 basis points, 50 in total, that actually has a much bigger impact than you would see on a 50 basis point cut from the SARB. That’s effectively what the market’s pricing in right now, is another two 25 basis point cuts from both the Fed as well as from the SARB.

My view on that is that it’s actually not terrible for banks because yes, it’s a cut, you know, it’s a slight cut, but it’s not cutting to a level where you would actually see a massive deterioration. And the South African economy arguably needs a little bit of an uplift just in terms of overall sentiment. People being able to go out there, buy their homes. I know South Africans love buying their cars, maybe they shouldn’t buy as many cars. I don’t see the net impact on South African banks as being that negative if we just see two cuts coming through from the SARB. If you actually see deeper cuts, I think the probability of that being low, then I’d start getting worried.

But Ghost, you touched on a couple of key points and we touched on the bank’s equity. That’s why when you’re looking at metrics, you’ve got to look at the Common Equity Tier 1 or CET1 ratio. That’s effectively how much capital the bank is holding in the highest tier of capital. That’s important to note because it tells you about the bank’s balance sheet strength.

Remember, I indicated to you it’s not as simple as when you’re looking at a conventional company and looking at the assets on the balance sheet. In this instance, you’re looking at that Common Equity Tier to inform how robust a bank is and how much, let’s call it dry powder they have to actually deploy in the markets.

Linked to that, you’ve discussed effectively the gap or the interest margin that comes through. You pay attention to that. That’s really related to the cycle, but tied to that is the non-performing loans. Here you’ve got to look at two things in my view. One is: what is the actual charge that is hitting the income statement in terms of non-performing loans? Have you seen that deterioration in terms of credit quality actually come through and hit earnings? But related to that, you’ve also got to look at: what is the bank’s provisions against non-performing loans? That’s a very important metric because that also tells you how defensive is the bank actually being, how defensive is their thinking in terms of making provisions for this deteriorating credit quality. That may just inform where the bank is specifically positioned in terms of their own growth cycle and lending that money out. That goes to some very important points that tie to specific metrics that you’re going to find on the bank’s financials.

 

The Finance Ghost: You’ll also see other stuff obviously, like the efficiency ratio which is the cost-to-income ratio. It’s kind of weird because you actually want it to be lower, so the term efficiency ratio is very misleading because higher is worse. Look out for that. Some banks just call it cost-to-income ratio which I think is infinitely more sensible really. And that’s just how well they manage their expenses versus their income.

I think as we bring this one to a close, banking is just a very interesting space. There’s a lot going on there. We’ve both worked in the industry. I think we both really enjoyed our time there. And for me personally in my portfolio Moe, I’m only long US banks, two of them, JPMorgan and Goldman Sachs because I just like the tilt towards investment banking and markets-type stuff that this combination gives me. Those positions have been very kind to me, so no complaints my side.

I’m not long any of the local banks. Last year it would have been tempting to say hey that would have been a good shout. But the US banks way outperformed anything locally. So once again that was the right choice.

I’m going to say this though: I think in 2025 there’s a chance that local banks might outperform the likes of a JPMorgan, just for a year because I think the rand might hold up, let’s see, I mean who on earth knows? But if just look at where that JPMorgan performance came from last year – and I don’t want to give away what’s in Premium – but 2025 could be a much slower year. Whereas I think in South Africa, you’ve got this recovery story, this GNU-sentiment – look, we still need to see the numbers coming through from that. At the moment, share prices have run miles ahead of the situation on the ground, but I think there’s a chance. I think if there’s a year where South African banks are going to outperform the US, this year is the best chance.

Does that mean I’m selling JPMorgan and putting all my money in banks locally? Absolutely not. Very happily long the US banks I’ll be long those things for a very, very long time. No local banking exposure for me personally at the moment.

 

Mohammed Nalla: Yeah, Ghost, that’s very interesting. I don’t watch the local banks in South Africa as closely as you do. That might be an interesting one that I’ve got to go and have a look at. The fact of the matter is that you’ve also got to look at what consumer balance sheets look like. That’s maybe a macro point that I touched on but didn’t emphasise because at the end of the day, the US consumer has been very robust because they got these checks – free money in the pandemic. They used that to boost their savings, then they’ve been drawing down on that.

You’ve got to watch that dynamic in South Africa. The health of the consumer balance sheet has been repaired versus the worst levels that we had seen some time ago. So maybe there’s some pent-up demand, credit demand that comes through. Maybe that actually helps your banking industry down in South Africa. Again, something to go and have a look at in terms of my own preferences.

A strong player like JPMorgan, that that goes without saying. You’ve got to look at that versus European banks that maybe are on a less stable footing. You’ve also got to look at Chinese banks where they don’t trade at the same kind of valuations, but they are significantly larger than their US counterparts when you’re looking at something like the assets that they have. Lots of dynamics.

And then lastly, just for me, I’m in Canada, so Canadian banks trade very similarly to South African banks. Their valuations aren’t as, let’s call it, robust as the US banks. They haven’t run as hard, they pay much higher dividends and it’s very much an oligopolistic industry in the banking market up here in Canada versus the US.

Those dynamics all determine whether you would consider one investment over the other. Are you investing for a dividend? Are you investing for the share price growth? Is it a bit of a combination of the two? I think that is uniquely tied to every single investor’s risk appetite and strategy.

Certainly no recommendations from us out there. That’s not what we do on the show. But I think banking as a whole as an industry, that’s an industry that I’m reasonably positive on for the year of 2025, just in aggregate based on where we are in the economic cycle.

Unfortunately, that’s all we have time for this week. So that’s where we’re going to have to leave it. Hit us up on social media. it’s @magicmarketspod, @financeghost, @mohammednalla, all on X or go and find us on LinkedIn. Pop us a note on there. We hope you’ve enjoyed this.

If you’re not in premium, go and check that out. A great report on JPMorgan. It’s just R99 a month for a report on a global stock every single week. It’s not just a podcast, it’s a report as well. Go and check that out if you’re not already a subscriber. Until next week, same time, same place. Thanks and cheers.

 

The Finance Ghost: Ciao.

 

This podcast is for informational purposes only and is not financial or investment advice. Please speak to your personal financial advisor.