Key Risks
While there seem to be some reasons to be cautiously optimistic about Bank of America’s long-term growth prospects, there are two main risks investors need to keep in mind.
First, Bank of America’s non-performing commercial loan ratio has been rising in recent quarters. While this hasn’t yet shown up in its net charge off ratio, it could be a troubling sign that the credit cycle is turning.
Specifically, recent changes in U.S. regulations pertaining to money market funds that went into effect October 14th have caused the short-term LIBOR, or London Interbank Offer Rate, to rise sharply in recent months.
The new regulations are designed to safeguard money market funds by raising liquidity requirements for these short-term investment funds, which make up the backbone of the massive commercial paper market.
Commercial paper are short-term (270 days or less), unsecured loans that make up the oil that greases the corporate world. Companies tap this market to ensure adequate liquidity to pay customers, as well as employees. So the concern is that this increase in LIBOR will result in a contraction (i.e. higher borrowing costs) that might hurt companies and threaten the still weak economic recovery.
That’s especially true now that interest rates are rising in anticipation of a Trump administration stimulus plan, which could combine large increases in infrastructure spending, as well as tax cuts and deregulation. Basically, these factors could spur short-term economic growth at a time when the labor market is close to full employment, resulting in higher wages (great news for consumers) but also potentially higher inflation.
That in turn could force the Federal Reserve to increase interest rates faster than it had planned, which could potentially bring about the next recession. While higher interest rates generally improve the profitability of banks’ lending operations, a recession wreaks havoc as customers struggle to repay their loans.
This brings me to the second major risk, which is the rumored roll-back of certain provisions of the Dodd-Frank regulations passed after the financial crisis. While we have yet to see any specifics, rumors are that we could see lower capital requirements (allowing banks to move cash from low risk, low yield treasuries to higher risk, higher-yielding loans), as well as end the Fed’s annual review of a bank’s capital plans, including how much profit can be returned to shareholders as buybacks and dividends.
Don’t get me wrong, I’m not saying that should such regulatory changes happen that Bank of America would suddenly revert back to its highly speculative and dangerous gambling ways of the past. After all, management has gone to great lengths to raise its capital ratios far above the regulatory minimums in the name of maximizing the safety of the bank’s shares.
However, in the event that Mr. Moynihan was to retire, my concern would be whether or not the conservative changes he made at this world spanning bank would stick. It’s always possible that rising complacency among short-term investors calling for faster earnings growth and faster capital returns could lead a new management team to potentially weaken the bank’s balance sheet to “just good enough to survive another downturn.”
If the financial crisis proved anything, it’s that erring on the side of caution is always best. After all, the history of banking and investment management has shown us that models can easily fail, and that “once in a century” or even “impossible” events can occur with frighteningly high frequency.
