DPST - Bank Fundamentals Remain Solid But Concerns Linger
2023-11-08 01:45:00 ET
Summary
- Regional banks trade cheaply compared to the “Big 6,” but investors should be tactical with bank allocations given ongoing asset and profitability concerns.
- Bank earnings were better than expected in the third quarter, with a majority beating EPS expectations.
- Asset quality continued to normalize but did not show major cracks thanks to the resilient U.S. economy and consumer.
By Andrew Arbesman, CFA
Regional banks trade cheaply compared to the “Big 6,” but investors should be tactical with bank allocations given ongoing asset and profitability concerns.
Bank earnings were better than expected in the third quarter, with a majority beating EPS expectations. Asset quality continued to normalize but did not show major cracks thanks to the resilient U.S. economy and consumer.
Capital levels improved, driven by the suspension of share repurchases. Deposit flows stabilized with bank deposits down only 1% versus the prior quarter, further validating the granularity and stability of the industry’s deposit base compared to the unique and “hot” deposits held by the banks that failed earlier in the year.
Despite these positive fundamentals, credit concerns continue to linger over the banking sector. Commercial real estate showed more signs of weakness, especially in offices, which is expected to be bigger issue for regional banks with less than $100 billion in total assets given their outsized exposure to the asset class.
Net interest income has plateaued, in our opinion, and will likely deteriorate over the coming quarters as funding costs remain elevated and loan growth slows for both corporate and retail clients.
Again, we believe this headwind will affect regional banks more than the largest U.S. banks, as the regionals’ funding costs have accelerated at a faster pace to attract deposits.
For example, the rate paid on interest-bearing deposits increased by 226 basis points for 28 regional banks since 3Q 2022 versus 188bps for the U.S. money centers.
Heightened credit concerns around regional banks have led to increased volatility in bank spreads and, in our view, potential investment opportunities.
Adjusted for ratings and duration, regional banks trade 50 basis points wider than the Big 6. As a point of reference, there was no difference at the beginning of the year and regionals were at least 25 basis points cheaper for an extended period prior to 2023.
While current trading levels suggest that regional banks are cheap, we do not believe that their spreads will “trade through” the Big 6 any time soon, due to the profitability and asset concerns and the increased debt issuance needed to meet upcoming regulatory requirements.
Given these factors, we believe investors should remain tactical and agile in relation to their bank allocations.
Moreover, we think they should maintain a preference for larger regionals with solid deposit franchises, diverse earning streams, low commercial real estate exposures, healthy capital and liquidity positions, and strong management teams.
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Bank Fundamentals Remain Solid, But Concerns Linger