Regional banks:
A league of their own

February 2017

As the first weeks of the new administration unfold, many investors are starting to assess potential winners and losers. While financials overall seem poised to benefit from Fed tightening and lighter regulation, regional banks may be particularly well-positioned due to their simplified, lending-focused business models.

Figure 1. Bank net interest margins correlate with interest rates

Figure 1. Bank net interest margins correlate with interest rates

Source: Bloomberg, as of February 7, 2017. Regional bank net interest margin is weighted average of trailing twelve month net interest margin of the securities in the Dow Jones U.S. Select Regional Banks Total Return Index. Past performance does not guarantee future results.


Changing regulation ahead

Regional banks are depository institutions that operate across groups of states but below the national level. These organizations could see significant regulatory relief under the new administration if they are legally differentiated from larger, more complicated bulge bracket banks, which represent the country’s largest multinational investment banks. For example, there are proposals to raise the $50B threshold for “Systemically Important Financial Institutions” (SIFI), a Dodd-Frank designation for 33 banks whose failure could trigger a financial crisis. With many regional banks currently grouped alongside bulge brackets under the current minimum, increasing the threshold could grant regional banks more operational freedom than their larger peers.

Reflation-driven economic tailwinds

Broadly speaking, regional banks earn revenue from lending and pay fees on deposits. When interest rates edge higher, the spread between income from loans (longer duration) and payments on deposits (shorter duration) typically widens, which can help increase bank profitability through higher net interest margins (NIMs). Although the low interest rate environment over the past decade has compressed bank NIMs (Figure 1), we expect U.S.-led reflation − rising nominal growth, wages and inflation − to accelerate. Markets could also be underpricing the possibility of earlier and larger rate hikes in 2017, given the Fed’s apparent increasing confidence in job and wage growth. This has paused further steepening in the U.S. Treasury curve, but yields could rise when the Fed signals more aggressively. Due to their lending-focused business model, regional banks may be among the best positioned financial firms to capitalize on higher yields and steeper curves.

Potential protection from
capital markets uncertainty

Regional banks’ relatively simplified structure could also make them more resilient to capital market headwinds than bulge bracket banks. The largest U.S. banks have seen fluctuating trading revenue in recent quarters, particularly in fixed income, while regional banks have typically not engaged in such activities. Regional banks also tend to be more domestically-focused, meaning their bottom lines may be less impacted by a strong dollar, which could potentially erode non-dollar revenue earned abroad.

Figure 2. Valuations have jumped since the
U.S. presidential election

Figure 2. Valuations have jumped since the U.S. presidential election

Source: Bloomberg, as of February 7, 2017. Regional banks represented by S&P Regional Banks Select Industry Index Price to Earnings and Price to Book ratios are both trailing twelve months. Past performance does not guarantee future results.


Conclusion

Although valuations have increased significantly since the election (Figure 2), regional banks may stand to gain the most among financials from impending regulatory easing and a more favorable macroeconomic environment. Performance will likely depend on looser regulations being successfully communicated and passed. Bulge bracket banks may not be as well-positioned due to their complexity, but could still perform strongly in a reflationary environment and may serve as a portfolio diversifier.


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Authors
Investment Strategist for ETF Investment Strategy
Associate for ETF Investment Strategy