RBC's Gerard Cassidy talks Big Banks hitting record highs

Key Concepts

• Yield Curve: The difference in interest rates between long-term and short-term bonds. A flattening yield curve can negatively impact bank profitability.
• Net Interest Income (NII): The difference between the revenue a bank earns from its lending activities and the expenses it pays to fund those activities.
• Non-Bank Financial Institutions (NFIs) / Non-Depository Financial Institutions (DFIs): Financial entities that provide financial services but do not accept traditional deposits like banks. Their increasing interconnectedness with banks is a growing concern.
• Basel III Endgame: Proposed banking regulations aimed at strengthening capital requirements and risk management practices.
• Nominal GDP: Gross Domestic Product measured at current market prices, including the effects of inflation.
• Monetary Easing/Tightening: Policies implemented by central banks to increase or decrease the money supply and credit conditions, respectively.

The Banks Trade: Risks and Opportunities in 2026

Introduction

The discussion centers on the current performance of large banks and the potential risks and opportunities facing the sector, particularly looking ahead to 2026. The primary concern revolves around the possibility of a resurgence in inflation and the subsequent impact on monetary policy, the yield curve, and credit quality.

Biggest Risk: Re-emergence of Inflation

Gerard Cassidy of RBC Capital Markets identifies the re-emergence of inflation as the biggest risk to bank stocks in 2026. Specifically, if inflation were to rise to 4% or 5%, the Federal Reserve might be forced to abandon its monetary easing policy and revert to monetary tightening by raising short-term interest rates. As Cassidy states, “The biggest risk for the banks would be a reemergence of inflation in the second half of 2026. If we see inflation running at 4 or 5%, and it forces the Federal Reserve to reverse its monetary policy…that, to us is the biggest risk to the bank stocks.”

Impact on Yield Curve and Credit Quality

Raising short-term interest rates would likely flatten the yield curve, reducing the benefit of growing net interest income for banks. Furthermore, higher rates could trigger a recession, leading to a credit cycle downturn. While current credit quality is resilient due to de-risking efforts post-financial crisis, a recession poses a threat. The interconnectedness of banks with Non-Bank Financial Institutions (NFIs) is also a point of concern, as the growth in this sector has been rapid and warrants close monitoring. Cassidy notes, “Rising short term interest rates could lead to a recession, which then turns into a credit cycle.”

Interconnectedness with Non-Bank Financial Institutions (NFIs)

The increasing interconnectedness between banks and NFIs is highlighted as a potential vulnerability. While banks have managed these relationships well historically, the rapid growth of the NFI sector necessitates careful observation for potential future problems. Jamie Dimon previously referred to early warning signs in this area as “cockroaches” or “mice.”

Current Gains and Pricing of Tailwinds

Despite these risks, the year-to-date gains in bank stocks have been substantial. Cassidy believes some further gains are possible, but acknowledges that many positive factors are already priced into the sector. The expectation of continued economic growth and favorable monetary policy are key drivers of this pricing.

Basel III Endgame and Regulatory Constructiveness

A significant development to watch is the finalization of the Basel III Endgame regulations, expected in the first quarter of 2026. This proposal is viewed as a crucial indicator of the regulators’ constructive approach towards the banking industry. Cassidy emphasizes that this will provide “further pieces of evidence to investors that the regulators are very constructive and are working with the banking industry.”

The Importance of Nominal GDP Growth

Loan growth in the banking industry is strongly correlated with nominal GDP growth, based on a regression analysis spanning 75 years. Recent nominal GDP growth reached approximately 8% in the latest quarter. This strong nominal GDP growth is expected to be a key driver of bank performance in the initial stages of 2026. The focus on nominal GDP, rather than real GDP (which adjusts for inflation), is crucial because loan growth is directly tied to the overall economic activity measured in current prices.

Logical Connections

The discussion flows logically from identifying the primary risk (inflation) to outlining its potential consequences (yield curve flattening, credit deterioration, recession). It then explores mitigating factors (current credit resilience, regulatory developments) and key economic indicators (nominal GDP growth) that will influence the sector’s performance. The interconnectedness of NFIs is presented as a developing risk that requires ongoing monitoring.

Conclusion

The outlook for banks in 2026 is cautiously optimistic. While current conditions are favorable, the biggest threat lies in a potential resurgence of inflation and the resulting policy response. Monitoring the Basel III Endgame regulations and tracking nominal GDP growth will be crucial for assessing the sector’s trajectory. The increasing interconnectedness with NFIs represents a developing risk that warrants continued attention. The overall message is that while banks are currently well-positioned, vigilance and proactive risk management are essential to navigate the potential challenges ahead.