RF - Regions Financial: Uncertain Simply Uncertain

2023-10-22 11:27:27 ET

Summary

• Regions Financial performed well in 2022 with relatively modest unrealized capital losses and strong deposit flow.
• The banking sector faced challenges with deposit outflows and liquidity issues, causing capital losses for many banks, causing a crisis this spring.
• Regions Financial's net interest income is now continuing to come down as interest rates are hiked to avoid deposit outflows, causing continued uncertainty.

Late in March, I believed that Regions Financial ( RF ) performed quite well as the bank did not face the same degree of deposit outflows in 2022 as many of its peers. Doing reasonably well from a deposit flow point of view, with relatively modest unrealized capital losses seen, the bank appeared to be a relatively strong performer.

On the other hand, idiosyncratic risks in the banking sector were really high at that point in time, creating risks, even for stronger performers. After the banking woes subsided during the summer, causing shares to rally to the $20 mark, shares have fallen to their lows again. This comes as third quarter results reveal the impact of continued higher interest rates to be paid to depositors, a trend set to continue and thereby weigh on earnings and cause continued uncertainty.

A Recap

The (regional) banking sector faced huge turmoil at the end of the first quarter, with banks facing two challenges. The situation arose as banks were flushed with deposit inflows since the pandemic. Following the aggressive interest rate hike campaign from the Fed in 2022, the banking sector at large was slow to hike deposit rates, not being competitive enough versus risk-free alternatives, thereby resulting in deposit outflows seen in 2022 already.

Besides the outflows, banks were struggling to maintain liquidity to meet deposit redemption requests. Once the liquid base of the bank were depleted, banks were forced to sell less liquid assets such as treasury and agency securities, with longer duration resulting in many of these assets trading underwater. That is no problem if you do not need to sell them, but as liquidity dries up, banks would need to sell them, incurring large capital losses along the way as the Fed stepped in to avoid such practices.

For the year 2022, the bank posted net interest income (ahead of credit loss provisions) of $4.8 billion, nearly a billion ahead of the year before. Pre-tax profits came in at $2.9 billion, although interest expenses rose sharply to $114 million in the fourth quarter.

Total assets for the year fell from $163 billion to $155 billion, with the deposit base down from $139 billion to $132 billion, with fourth quarter outflows totaling $3.6 billion. With interest expenses trending at $450 million a year, the company paid an average of just 34 basis points on the deposit base in the fourth quarter, making it very hard to avoid deposit outflows.

The loan book of the bank rose by more than 10% to $95 billion, as a portfolio of $28 billion in securities available for sale traded with over $3 billion in unrealized losses. This created a serious hole on a $15 billion equity base, but not enough of a hole to create a massive crisis.

While the share price looked quite attractive, with Federal programs and assistance on the rise at the time, it was the idiosyncratic risks which made me cautious.

Stagnant

Shares of Regions Financial fell from the $20 mark to the $15 mark in May as there was another round of turmoil in the banking sector. As the worries subsided over the summer, shares of Regions Financial recovered to the $20 mark in August, but have sold off to lows of $15 again.

The bank posted first quarter results in April. First quarter net interest income of $1.43 billion actually rose a percent on a sequential basis as the bank posted earnings of $0.62 per share. The interest offered on accounts was not sufficient to halt the outflows in the deposit base, with average deposits falling from $133 billion in the fourth quarter of 2022 to $129 billion in the first quarter of the year. This was in part the result as interest expenses for the quarter totaled just $224 million with the company paying an average of 70 basis points on deposits.

Second quarter results showed that net interest income fell to $1.39 billion, with higher cost of borrowing and liabilities resulting in earnings falling to $0.59 per share. Average deposit balances fell to $125.5 billion, although it improved to $127 billion by the end of the quarter. Quarterly interest expenses of $358 million make that average rates paid on these deposits just exceed 1%.

Investors have reacted to the weakness which was seen in the third quarter results , with net interest income falling to $1.30 billion, as earnings fell further to $0.49 per share. Average deposit balances stabilized at $125.2 billion, but this came at the expense of lower net interest income.

Interest expenses of $475 million suggest that the bank pays an average of 1.5% on deposits and that is actually sufficient to stop deposit outflows here, which is quite surprising as risk-free rates come in around 5% here. The continued move higher in interest rates meant that unrealized losses jumped to $3.6 billion, a huge amount but manageable with equity reported around $16 billion.

What Now?

The reality is that current earnings power of around $2 per share looks compelling with shares trading at $15, as the balance sheet situation appears manageable. The issue is that average payments on deposits only amount to 1.5% here (including tens of billions in non-interest yielding liabilities). Hence, investors should embrace for more earnings pressure as the gap with risk-free rates at 3-4% is still huge, and closing the entire gap would mean that the bank would post huge operating losses.

The other issue is that Regions is still considered a regional bank, and that the current market conditions favor the big banks, with the implicit bailout guarantee for larger banks being stronger.

While the current earnings multiple looks compelling, it is the latest move in interest rates which causes more earnings pressure, as banks are rapidly hiking interest offered on savings accounts to withhold deposit outflows.

While no further deposit outflows are seen, it is the gap between current rates offered and risk-free rates which likely weigh on earnings in the quarters to come (let alone if provisions for credit loss would arise). It is exactly this cadence which makes me cautious as renewed volatility in the banking complex is likely expected here.

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