QABA - Looking Through Banking Weakness
2023-05-02 01:22:00 ET
Summary
- While uncertainty has increased, we believe fundamentals remain largely solid for the U.S. banking sector.
- Much of what happened in March, and later in the failure of First Republic Bank, was idiosyncratic rather than a “regional bank crisis.”.
- We believe banks offer value and trade cheaply on a rating- and duration-adjusted basis relative to industrials.
By Andrew C. Arbesman, CFA, CPA
As we move past earnings season, perceived vulnerabilities in the banking system are subsiding, offering investors value in the money center banks.
While uncertainty has increased, we believe fundamentals remain largely solid for the U.S. banking sector. Balance sheet factors—capital, liquidity and asset quality—which are the most important for credit fundamentals, remain supportive for the vast majority of issuers. Post 1Q earnings, we expect profitability to be affected by rising funding costs, and loss provisions to increase for certain loan types like commercial real estate ((CRE)). Additionally, regulatory requirements for capital and liquidity could become even stricter, particularly for regional banks. However, we see these issues as manageable in scope and longer term in nature, unlike the drastic and sudden forces that recently led to failure or stress for a small number of banks.
The events in March exposed heightened vulnerabilities for certain U.S. regional banks with concentrated, uninsured deposit bases and unrealized losses on securities and/or loan portfolios, which had grown considerably in the low-yield environment of 2020-21 and were then affected by Federal Reserve rate hikes in 2022. However, we believe that U.S. banks are generally better insulated from these vulnerabilities. In other words, much of what happened in March, and later in the failure of First Republic Bank ( FRC ), was idiosyncratic rather than a “regional bank crisis.”
This thesis has been supported by recent bank earnings. In general, 1Q results highlighted stabilizing deposit flows, moderating borrowing from Fed liquidity facilities, improving liquidity and normalizing—but not deteriorating—asset quality. Office CRE remains challenged and will remain so for several years. That said, we do not think CRE will be a systemic issue for the banking system. On average, banks with more than $100 billion in total assets (ex. U.S. global systemically important banks) have mid- to upper-teens exposure to CRE as a percentage of total loans. Importantly, office CRE ranges from 1 – 7% of total loans and is underwritten with fairly conservative, original loan to value ratios in the 50 – 60% range.
Given these views, we believe banks offer value and trade cheaply on a rating- and duration-adjusted basis relative to industrials. In particular, we prefer the large money center banks over regionals given their greater diversification, larger scale, more robust regulatory oversight, less exposure to CRE and incremental earnings contributions from trading and advisory businesses that have benefited since the onset of the pandemic. Finally, issuance that plagued market performance last year is expected to be down notably versus last year, providing a positive trading technical for the money center banks.
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Looking Through Banking Weakness