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The recent dislocation among US regional banks is potentially creating an investment environment reminiscent of the recapitalization theme from the global financial crisis (GFC). In this current crisis, we anticipate that banks will eventually need to raise a meaningful amount of capital to address asset/liability mismatch issues resulting from rapidly rising interest rates. Although that capital-raising process has not yet begun, in the interim, we see significant dispersion in stock price returns between the strongest and weakest banks. In our view, this is one of the most compelling environments for stock picking in the financial services sector since the GFC.
Regulators have recently made it clear that meaningful changes are coming for all banks with over US$100 billion in total assets. The direction of travel is toward an expectation of higher capital requirements and greater liquidity. Regulators appear to have ambitious plans to institute new policies, but also seem to have limited capacity to finalize and implement all the desired rule changes. Instead of a holistic review of regulatory requirements for banks, regulators are therefore adopting a piecemeal approach and will release proposals for new regulations over time. This means that it will likely take at least 12 months (if not longer) before we understand the full extent of the scale and impact of new regulations on banks’ balance sheets and profitability.
There is also broad recognition that the US Federal Reserve (Fed) did not adequately supervise banks in recent years, although it is not the only regulator to share the blame for the banking system’s troubles. In our view, the Fed is expected to respond to this criticism by being more aggressive in its supervisory and examination roles going forward.
Legislatively, the priorities will likely be limited by a divided Congress. Reform of the current deposit insurance scheme is not on the current legislative agenda. The only areas with some bipartisan support are an executive compensation clawback bill for failed banks (the RECOUP Act) and perhaps tighter oversight of the Fed. The use of the systemic risk exemption after the failure of Silicon Valley Bank has raised questions about how the Fed reached that decision, and lawmakers are likely to push the Fed for transparency on supervision going forward.
For regional banks with US$100 billion or more in assets, the most meaningful near-term rule change will likely be the inclusion of unrealized securities losses in capital ratios, phased in over multiple (likely three to five) years. As shown in Figure 1, most of the top regional banks are currently well below the 9% Tier 1 capital ratio threshold when adjusted for unrealized losses. We also expect a new proposal to include bail-in debt (TLAC) and over time, additional changes related to stress testing and liquidity requirements. Overall, higher capital requirements could lead to lower returns for banks, although the scale remains uncertain given the significant number of rule changes that are expected.
M&A activity is another key topic that has been top of mind in the regional bank space. While regulators are warming up to the need for more mergers, more active regulatory encouragement will likely be necessary before we see greater consolidation. The Fed could help lead this process, as lower interest rates would help reduce the amount of unrealized losses on bank balance sheets, making it easier for both buyers and sellers to get deals done. Additionally, new regulations that impact all banks with over US$100 billion in assets will be a significant factor that will also lead to more consolidation over time.
In addition to the regional banking sector’s capital and liquidity considerations, banks continue to face headwinds from the increased cost of funding, the impact of elevated volatility in rate markets, and deteriorating credit quality. All of these factors are affecting individual banks to varying degrees, causing a high degree of stock-price dispersion and thereby creating opportunities for long/short investing in US regional banks.
Looking ahead to 2024 and beyond, we still expect capital raising to be significant across the banking industry, even if that process may play out over time rather than in a short-term flurry of activity. The eventual pace will depend on a range of factors, including regulatory guidance, interest-rate expectations, recession dynamics, and the evolution of the credit cycle.
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