Banks' Ability to Lend Is Key to Trump's Planned Business Boom

The dual prospects of a Donald Trump presidency and further interest-rate increases lifted banks' shares in the closing weeks of 2016. This year will reveal whether a new economic order will actually emerge, and boost banks' businesses with it.

The outcome is crucial for both broader markets and the nation's outlook for growth. Financial stocks are a big part of the S&P 500, and banks' ability and willingness to lend could prove critical to the business boom the Trump administration aims to generate.

So far, markets are upbeat on the possibilities, betting banks will benefit from higher rates, that other businesses can tolerate them and that less regulation and lower taxes will help the economy overall.

The S&P 500, which plummeted at the start of 2016, closed the year up 9.5%. Meanwhile, the Dow Jones Industrial Average rose 13%.

The jubilation is particularly apparent among financial stocks: Among S&P 500 sectors, financials were the second-best performer in 2016, up 20.1%.

The KBW Bank Index has risen about 22% since Election Day, hitting its highest level since 2009. That is a dramatic reversal for an index of large national and regional banks that had spent the first 10 months of the year below its year-prior levels and at some points hit multiyear lows.

The gains reflect investor expectations for the broader economy since the firms' big revenue generators -- lending, trading and capital-markets activity -- are closely correlated to economic growth, interest rates and the steepness of the yield curve, or the difference between long- and short-term rates. The bigger the difference, the better it is for banks because they borrow short term and lend long term. Expectations for higher rates and a steeper yield curve have been rising since the election, while the Federal Reserve has echoed that by signaling three more interest-rate increases could be in store in 2017.

Another plus for banks: the idea that the Trump administration will usher a less onerous regulatory environment. Less regulation could allow banks to boost profits and capital returns to shareholders.

If there is a problem for bank-stock investors, it is that shares are priced at levels that suggest the future is already here. "While we're constructive on banks, the rapid rise has us nervous," said Terry Gardner, a portfolio strategist at investment-management firm C.J. Lawrence.

And soaring share prices have pushed up some valuation measures sharply, in many cases beyond historical averages.

Shares of five of the six largest U.S. banks -- J.P. Morgan Chase & Co., Bank of America Corp., Wells Fargo & Co., Goldman Sachs Group Inc. and Morgan Stanley -- are trading at more than 13 times forward earnings estimates, compared with averages of between 10 and 12 times over the past 15 years, according to FactSet. Citigroup Inc. is the only laggard, trading at just shy of 12 times forward earnings, although that figure is still up sharply from less than 10 times before the election.

But valuations may appear lofty because many analysts haven't yet formally adjusted earnings forecasts in light of the election. If those climb, valuations will look more reasonable.

For example, a combination of accelerated share repurchases -- a possibility if the Trump administration appoints less-stringent banking regulators -- steeper yield curves, accelerated loan growth and more-robust trading and investment-banking revenue could push earnings per share for big banks up by 18% over analysts' pre-election estimates, according to Credit Suisse bank analysts.

And potential changes to corporate-tax rates could boost bank earnings further, even if some may take hits to tax assets on their books generated by prior losses. Sanford C. Bernstein bank analyst John McDonald recently estimated that cutting the corporate tax rate to 20% from the current 35% would raise Wells Fargo's earnings per share 18% above the firm's 2018 forecast. J.P. Morgan's earnings would rise by 13%, Bank of America's by 12% and Citigroup's by 10%.

Just how much benefit further regulatory changes could bring is less clear, although investors are betting they will do more good than harm.

As a candidate, Mr. Trump promised to roll back the Dodd-Frank Act, the postcrisis law that dramatically increased regulatory oversight of the U.S. financial system as a whole and banks in particular. In response, lenders have had to increase the amount and quality of their capital and available liquidity, revamp their trading operations, and extend the duration and stability of the debt they use to fund themselves.

Many observers have suggested that these changes are responsible in part for the low returns on equity banks have reported in recent years. Those low returns have depressed bank valuations.

But dramatic changes to the regulatory environment -- including a possible repeal of Dodd-Frank itself -- wouldn't immediately boost bank profitability. The changes banks have made to their operations and funding can't be instantly reversed, even if that were what banks wanted to do. And there are indications banks aren't looking for a complete reversal of regulatory direction.

"We don't need to tear up the rule book," said Francesca Carlesi, head of regulatory affairs at Deutsche Bank. "We need time to digest the rules we have."

Academic studies also suggest it can take banks several years to adjust to major shifts in regulation. In the short term, that could actually be a drain on earnings as banks may have to spend more to adjust compliance systems around new rules.

While banks have been the come-from-behind underdog stocks of 2016, little of their gains are due to anything the firms themselves have done. In 2017, their fates will also be largely decided by forces outside their control.