Equity Insights – Regional Banks Are Morphing Into Zombies

Summary

• Regional banks show few signs of recovering more than 10 weeks after the Silicon Valley Bank collapse. To be blunt, the crisis is morphing into a slow-moving trainwreck.
• The regional bank ETF KRE is down 26%, reflecting expectations that rising deposit rates will squeeze net interest margins and higher capital requirements will erode returns on equity.
• About a third of regional bank stocks are effectively zombies, although it may be a while before that becomes obvious.
• Banks involved in mergers with the failed banks have done spectacularly well thanks to sweetheart deals with the FDIC.
• Clearly, consolidation is the way to go, but that scenario may take time to develop.

Market Implications

• Zombie banks will not create a credit crunch that stops the economy, but they will be a drag.
• We advise avoiding weak banks for now, even if they appear cheap. They will do well if acquired – but if that happens via FDIC intervention, shareholders will be wiped out.

Regional Banks Hit a Wall

Spring has been painful for investors in regional banks. Since the Silicon Valley Bank failure, the S&P 500 (SPX) has rallied 9% while the regional bank ETF KRE is down 25% and still looking for a bottom (Chart 1). The bank washout has had little impact on the broader market, largely because banks account for only about 2.8% of the SPX. Regional banks in KRE (most of which are too small for SPX) total only about 0.9% of the SPX.

Further, the large bank ETF KBWB is down only about 10%, but that is entirely due to the four too-big-to-fail money centre banks – JP Morgan Chase (JPM), Citigroup (C), Bank of America (BAC), and Wells Fargo (WFC). Those banks are collectively down 3.5%; ex those banks, KBWB is down 24%.

So, it is all about the regional banks.

We see little prospect of a speedy recovery in this sector. They face at least two obvious hurdles.

First, they will have to raise rates on deposits or risk seeing funds leak to higher-yielding money market funds. It may be hard to believe, but the average rate on bank savings accounts is still only 0.25%! Meanwhile, money market funds are paying upward of 4.5%. The consequence will be lower interest margins and earnings. If lending slows due to higher loan rates and a slowing economy, that will pressure interest margins further.

Second is the prospect of tighter regulation. Congress raised the threshold for bank stress tests from $50bn in assets to $250bn in 2018. The lower figure will likely be reinstated, thereby increasing costs for larger regional banks. Today, only one regional bank is above the $250bn threshold; some 18 are above $50 bn.

In addition, banks may be required to hold additional capital against unrealized losses on securities, which will reduce return on equity. There has been little movement to tighten regulation so far, but investors clearly expect something.

These issues are of less concern for money centre banks as they have more diversified sources of funding and are already subject to tight regulation. And they could gain deposits and lending business from weaker regional banks due to their too-big-to-fail status.

Zombie Banks Rule the Roost

Regional banks have done poorly at an index/ETF level. That pales in comparison to the performance of many individual banks. In the regional bank ETF KRE, stocks for 31% of the banks are down more than a third (Chart 2). Many of these banks are small, with less than $20bn in assets. These smaller banks hold about 23% of the assets in the KRE index, but are two-thirds of the index by number. One crazy outlier is up 33% – more on that below.

The large bank ETF KBWB only has 21 members, but about half are down by 30% or more (Chart 3).

By now, most of these banks are more or less known-knowns. Analysts have picked through their balance sheets and asset/deposit mixes, learning which banks have stronger versus weaker franchises. Barring some major new development, such as mergers or regulatory change or a sharp and sustained decline in interest rates, these relative valuations are unlikely to change much.

From our standpoint, the weaker banks are, for all practical purposes, zombies. It may take further rate hikes and an economic slowdown for that to become obvious.

Consolidation Is Coming

We think consolidation is inevitable among regionals and, by extension, among the additional 4,500-odd small banks scattered around the country. There is no upside in having legions of zombie banks that are marginally solvent at best and unable to lend or pay market rates for deposits.

Banks in a position to acquire weaker banks may have significant upside, depending on the circumstances.

The banks that acquired the failed Silicon Valley Bank (SIVB) and Signature Bank have done spectacularly well. First Citizens BancShares (FCNCA) is up 220% from the lows after winning SIVB; New York Community Bancorp (NYCB) has gained 163% after acquiring SBNY. Both significantly outperformed SPX – something no other banks can say. JP Morgan Chase also rallied after acquiring First Republic Bank (FRC) but still trades below the pre-SIVB price.

Granted, these acquisitions benefited from FDIC support. Stronger banks may hold off on acquisitions unless they can get them on similarly favourable terms – whether following an FDIC intervention or because some banks have no choice but to accept onerous terms.

Given the FRC situation festered for seven long weeks after the SVIB collapse, it is apparent the FDIC is in no hurry to address weak banks. Rather, it seems to be hoping that the market takes action, they somehow recover over time, or (worst of all) the problem will go away if they ignore it. This was the strategy during the 1980s when the thrift industry turned into a slow-moving train wreck. That did not end well.

The bottom line is that regional banks as a sector are likely to remain depressed until something happens to drive the consolidation wave.

How to Play This Situation?

There is no obvious way to position for this consolidation today. It is difficult if not impossible to identify the banks that will emerge as winners.

We do not recommend investing in weaker banks currently. If they are acquired by another bank, investors may benefit. But if they are taken over by the FDIC, shareholders will be wiped out.

We expect the zombie regional banks to last for a while, gradually growing weaker and vulnerable should any crisis develop. We suggest investors be patient and watch the sector, both for its likely deleterious impact on the economy and potential emerging opportunities.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)