Is it a True Revival for Regional Bank Stocks or Another Deceptive Rally?

Following the bank collapses and significant interest rate hikes in March, regional banks have been grappling with rising funding costs, tighter regulations, and deteriorating credit quality. However, as inflation cools and the prospect of potential rate cuts looms, market sentiment could shift. Lenders such as KeyCorp, Zions, which were previously affected by early-year banking turmoil, have seen their fortunes rebound from October's lows. Yet, according to Bloomberg data, not all regional bank stocks are justified for an uptick.

The recent decline in interest rates has reduced banks' Available-for-Sale (AFS) or Held-to-Maturity (HTM) losses, but the decline in economic momentum has also reduced new loan yields. Such volatile interest rate swings still pose challenges to bank balance sheets.

Financial Times columnist Robert Armstrong noted that paper losses seem unlikely to matter much. The losses at Silicon Valley Bank and First Republic mattered only because the banks also had low margins and loads of uninsured deposits, and ran into liquidity crises. Besides, the Fed’s Bank Term Funding Program is still open.

Banks face more challenges ahead. For Example, loan growth has been falling steadily all year. The new regulation of Basel III is part of the reason. Falling inflation means that even if the Fed stops raising interest rates, real interest rates are actually rising, curbing demand for new loans. Meanwhile, long-term investors are waiting for further evidence that a soft landing is going to show up for them.

According to Bloomberg data, the anticipation is that many banks may not see their net interest margins bottom out until the first quarter of 2024, with some possibly not rebounding until later in the year.

Although there are some banks that see alleviation of NIM pressure, like First Horizon expects to see a reprieve as the effects of aggressive deposit marketing strategies implemented in the second and third quarters diminish, institutions such as U.S. Bancorp and Huntington are signaling the potential end of their margin declines.

The general market view is that some regional banks will hit their lowest net interest margins by the first quarter of 2024. Nevertheless, other banks such as Bank OZK may lag behind due to persistent deposit-cost headwinds. First Citizens is also contending with challenging comparisons as the advantages from the Silicon Valley Bank acquisition begin to wane.

Compared to the largest banks, regional lenders have lower reserve ratios for various loan types. Overall, regional banks show a median reserve of 1.3%, lower than the 1.6% seen at the biggest U.S. banks, partly due to a different loan composition. For CRE loans, the largest banks hold a median reserve of 1.9%, slightly above the 1.8% held by regional banks.

There is also significant variation among regional banks in their reserve allocations for the 'other consumer' category, which includes loans for auto purchases and education.

Amidst a challenging environment marked by high vacancy rates and rising interest rates, banks have been closely monitoring their office property exposure. Recent sales of distressed office properties have provided a clearer picture of market values, prompting banks to increase their financial cushions.

The conservative loan-to-value ratios, averaging between 55-60%, reflect cautious underwriting practices, offering a buffer against potential losses. However, the strain is becoming evident, with banks such as PNC and Zions reporting an uptick in nonperforming office loans in the third quarter.

When assessing the scope of exposure among regional banks, office commercial real estate (CRE) loans average around 2% of the total loan portfolios. Bank OZK, while having the highest exposure at 8%, leverages its extensive experience in credit risk management to navigate the sector's current uncertainties.