Regional Banks Show Resilience Amid Industry Challenges

Bank failures are jarring events, bringing clarity only to the institutions involved. Federal regulators close them, and other banks pick up the remaining assets and deposits.

These collapses trigger uncertainty, causing regulators and investors to fear that they may have missed unobserved problems in the banking system. That’s what we saw in spring 2023 when four large regional banks succumbed to bank runs.

Since then, no other banks have failed except a tiny bank in Kansas. But questions linger about the industry, particularly the health of regional banks.

The second-quarter earnings season has helped clarify where we think things stand.

Q2 Earnings Reveal a Shifting Landscape for Regional Banks

After the banking crisis earlier this year and a surge in deposit outflows, the story has changed as we look at second-quarter earnings. Regional banks now show signs of more stability.

As we approach the end of this rate-hiking cycle, we believe we could start to see stability in regional banks' net interest income (NII) and net interest margins (NIM) — both measurements of a bank’s profitability and performance — as the upward pressure on deposit costs starts to decline.

We've seen this trend toward the end of previous rate-hiking cycles and believe similar dynamics this time should allow investors to assess regional banks' earnings power better and more confidently underwrite earnings per share (EPS) expectations.

Moreover, we still don't see a spike in delinquencies and charge-offs (i.e., writing off debts as losses) in regional bank loan portfolios. The rates of both are ticking upward, but we see that as the resumption of normal levels.

A bit of good news surfaced in second-quarter earnings reports for banks with less than $50 billion in assets. For the most part, they met or beat earnings expectations. Among the institutions covered in the KBW Bank Index*, 34% missed expectations.

While credit quality remained strong, we saw loan growth continuing to slow, which we expect to continue because interest rates have increased and banks have tightened their lending standards.

Also slowing were deposit outflows, which jumped in the first quarter as customers reacted to bank failure headlines and wondered if their banks were at risk. Still, the effects of those deposit outflows lingered, mostly in banks offering higher interest rates to compete for deposits. Paying higher interest rates to depositors brought down NIM and NII in the second quarter.

Nonetheless, several bank management teams we’ve talked to think the dip in NIM and NII has or will soon reach the bottom because they expect the Federal Reserve (Fed) to let up on interest rate increases. If this prediction holds true and deposit outflows stabilize, the repricing of loan and investment securities could help NIM and NII during the second half of the year.

Capital Strategies, Mergers and Credit Downgrade Impacts

Several banks have told us they would prefer to shore up the capital on their balance sheets because the economic outlook remains uncertain, so we see fewer stock buybacks for now. We expect banks to maintain strong regulatory capital levels.

The recent acquisition of PacWest Bancorp by private equity without government assistance was well-received in the market. But we don’t expect to see much more merger activity any time soon because higher interest rates complicate the math behind these deals.

Mergers have also taken longer to close under the Biden administration, which has held that more consolidation and less competition among banks is bad for customers. For example, the Columbia Banking System-Umpqua Holdings Corp. closing in March came nearly 18 months after the merger announcement.

Moody’s made news when it downgraded 10 banks in August, claiming that reduced profitability would make it harder for banks to generate internal capital. It placed six larger banks, including the “too-big-to-fail” BNY Mellon, on a watchlist for possible future downgrades.

Adding to scrutiny from credit rating agencies, Fitch recently said it may also downgrade U.S. banks, which caused bank stocks to fall the week of August 14. Fitch cited regulatory gaps that don’t solve problems like asset-liability mismatches and deposit concentrations. S&P 500 in late August downgraded five regional banks, offering a similar rationale as Fitch and Moody’s.

Downgrades by rating agencies can increase the cost of capital for the banks in question. But in our view, the actions by the rating agencies didn’t reveal anything that wasn’t already apparent about the condition of banks.