Failures, Funding and Financial Resiliency: 1Q 2023 Bank Earnings

Figure 3:  Capital ratios improved over the quarter: Common Equity Tier 1 Capital (%)

Capital ratios were generally stable in Q1 2023 as banks did not grow assets in the quarter. Banks signaled they are taking a cautious approach to returning capital to investors as uncertainty remains, especially if unrealized losses on securities portfolios grow. JP Morgan noted a desire to keep some dry powder in slowing stock buybacks. PNC also pulled back.

There is no clear view that banks are in need of more capital, aside from the inability of bank equity prices to bounce off recent lows.

Figure 4:  Regional Bank Price To Book Values Are Now Below 1x: Market Valuing Businesses Less Than Stated Equity

However, a significant increase in deposit costs over the medium term and/or higher terminal interest rates could encourage certain banks to reassess taking losses from selling lower yielding investment securities and re-investing the proceeds into higher yield securities as a means to boost net interest margins, and raising equity to offset the loss. Whether banks take such an approach is questionable given the bad experience of Silicon Valley Bank attempting such an endeavor.

Banks may need to retain more capital in order to bolster capital resources over the next few years. Most notably, we expect a now broader group of US regional banks to be subject to stricter capital and liquidity regulations as banks with assets of at least $100 billion are expected to fall under new rules. Previously, increased regulation was planned for banks with assets of over $250bn. New rules will likely include more banks being required to issue bail in-able senior unsecured debt. The issuance of this debt could weigh on prices of regional bank debt.

Lastly, regulators are also said to be looking at the possibility of including unrealized security losses in banks’ regulatory capital ratios for both available for sale and held to maturity bond portfolios. This would be phased in over time, giving banks the opportunity to build capital and for bonds to pull to par.

Considering all these factors, banks will likely only look to selectively grow their balance sheets, resulting in a tightening of their appetite to make new and extend existing loans. JP Morgan projects a very large slowdown in bank lending growth (from 12% last year to 2% this year) could be a 0.8%-point drag on GDP growth.

Funding: Flows to Larger from Smaller Banks: Profit Hit to Smaller Banks

Our focus on the quarter was to uncover evidence of deposit migration away from smaller regional banks toward the larger, more regulated banks.

There were signs of deposit migration. Overall industry-wide deposits declined by 3% Q/Q, but the declines were not evenly felt. The larger banks saw declines of just 1% Q/Q. However, the regional banks saw deposits decline by 2%, though the percentage varied with PNC seeing flat deposit growth while Comerica, a commercial bank with a larger uninsured depositor base, saw deposits fall by 9% Q/Q. Most striking was that JP Morgan saw deposit inflows of 2% Q/Q reflecting its perceived “safe haven” status. No other banks experienced deposit inflows.

Figure 5: Total Deposit Flows: Migration From Smaller To Larger Banks, Quarter On Quarter

Thus, in spite of a decade’s worth of regulatory efforts, there is still the view that the larger banks will receive government support in the event of a crisis. (See Figure 5 above)

Reassuringly for the sector, according to a majority of banks indicated that the larger outflows of deposits following the collapse of Silicon Valley Bank lasted for just a few days and have now abated.

However, banks experienced notable flows from zero or low cost deposit accounts into higher yielding accounts. To retain deposits, banks had to increase interest rates on deposit accounts as depositors woke up to the option of higher interest rates being paid on higher yielding deposit products and alternatives. With the possibility that the Federal Reserve continues to raise interest rates and/or keeps rates higher for longer, the risk is that funding pressures continue, especially as costs of interest bearing deposits for the sector are around 1.8% while T-Bills are yielding around 5% and money market funds over 4.5%. (See Figure 6 above)

According to JP Morgan Research from April 2023, banks across the sector had to increase deposit rates with larger banks experiencing deposit cost increases of .51% to 1.79% while smaller regional banks increased deposit costs by .56%.

Figure 6: Deposits Are Both Declining And Moving To Higher Rate Deposit Accounts: Deposits Of Larger Banks Demand Vs Non-Interest Bearing

As a result, net interest margins were generally pressured, with regional banks experiencing the most pressure with net interest margins down by 7 basis points on average, though some banks like Comercia, Key and Zions saw nearly a 20 basis point contraction. (JP Morgan Research, April 2023)

Figure 7:  Larger Banks Net Interest Margins Did Not Decline As Much As Those Of Smaller Banks

Funding costs are likely to remain elevated for the foreseeable future as the Federal Reserve keeps rates higher for longer, which likely means banks’ profitability will suffer. Profitability could be more pressured for smaller regional banks as net interest income contributes more than two-thirds of their revenues.

An investor concern is that banks will need to increase deposit rates closer to money market yields. However, using history as a guide and taking the view that depositors derive more value from their bank accounts than just earning interest, it is likely that deposit costs could increase to around 50% of Fed Funds. This would mean overall deposit costs would move from current levels of around 1.15% to 2.50%-2.75%. This would certainly materially impact profitability. JP Morgan estimates average return on equity could be lowered by 7 points for the smaller banks.

Deposits are also leaving the financial system as the Federal Reserve implements Quantitative Tightening and COVID stimulus savings are consumed. It is worth remembering that COVID induced stimulus programs created a $2 trillion increase in deposits. If we assume the entire COVID deposit bump were to outflow, this would imply a 10% reduction in system-wide deposits from the 2021 peak. We are likely already 50% there as around $1 trillion of surplus deposits remain in accounts, and JP Morgan estimates some regional banks have already experienced at least a 10-12% decline in deposits.

It is worth mentioning that there was virtually no loan growth across the banking sector in Q1 2023. Looking forward, loan growth expectations were lower by several smaller regional banks on account of lower deposit growth outlooks. Specifically, loan growth expectations were reduced from mid-to-high single digit growth rates to mid-single digit. There is a lot of focus on whether regional banks are pulling back on lending given deposit outflows, higher deposit costs and the need to retain capital given pending regulations. Bank management teams pointed to scaling back exposure to commercial real estate, notably office, given concerns of weaker appraisal values and shrinking debt service coverage ratios (see below for more details).

Figure 8:  Total System-Wide Deposits Are Falling

Financial Resiliency of the Larger Banks: Office CRE a Focus

Bank credit investors want banks to be profitable as profits act as a first line of defense.

Similar to deposit trends, larger banks outperformed their smaller peers in terms of profitability as strong net interest income and capital markets businesses underpinned revenues. The diversification of revenues across business lines is a source of strength for large banks.

Profitability can be measured by pre-tax pre-loan loss provision revenue (PPNR). The larger banks saw PPNR increase by almost 20% q/q while smaller regional banks experienced a decline of 10% on average, from a combination of lower interest income and fees.

Figure 9: Larger Banks’ Pre-Tax Pre-Provision Revenue Rose While Regional Banks’ Fell (% Q/Q)

Figure 10: Larger Banks‘ Loan To Deposit Ratios Are Better Than Smaller Banks

We believe the size of larger banks confers natural advantages, including broad funding bases where deposits are just one source of funding and loan to deposit ratios are less than 60% vs. regional peers at over 80% (see Figure 10 above). Combined, these factors make larger banks more resilient to stresses.

Lastly, a growing topic of investor interest is banks’ exposure to commercial real estate, especially the office sector.

Bank management teams pointed to additional weakness in the office sector with a rising level of criticized assets. Overall, there is approximately $100 billion of annual office loan maturities through 2027. This likely plays out over time rather than as one cataclysmic event, as lenders can work with borrowers to find solutions.

Looking at some specific banks, for example, PNC has 2.7% of loans tied to offices and it noted that criticized loans within its office loan portfolio stood at 20% and that multi-tenant loans, of which office represents 58%, have a mid-70% occupancy range. Wells Fargo noted it is de-risking its office portfolio; however, it is not seeing signs of stress, at least in the near term. Wells Fargo has 3.8% of its loans tied to offices.

Our broader concern is with the smaller banks. Banks with assets of less than $100 billion hold 65% of the banking sector’s total exposure to commercial real estate.

Figure 11: Banks Office Exposure ($ And % Of Loan Books)

Furthermore, over the course of 2022, smaller banks made up 30% of office lending, up from 20% in 2021. This poses the risk that smaller banks are exposed to more regional and lower quality property types where asset values may be at more risk from impairment. 

Figure 12: Cmbs, Banks, Insurance Have Averaged 85% Of Office Lending Since 2015

Portfolio Implications

We favor owning larger banks with diversified revenue and funding sources. Typically these are the G-SIBs, the globally systemically important banks. We believe these banks benefit from scale in terms of a broad range of revenue streams as well as being required to adhere to more stringent liquidity and capital ratios.

However, we believe the recent underperformance of some larger regional banks has created compelling investment opportunities, especially in names with strong retail deposit franchises, capital resiliency and less exposure to weakening commercial real estate sectors. With greater regulation to be imposed on larger regional banks, we expect the valuation disconnect that has currently opened to close in due time.

At the same time, we remain watchful of the broader implications of the smaller regional banks curtailing credit creation and whether this restricts the ability of smaller companies to expand. 

Figure 13:  Regional Banks’ Credit Spreads Are Still Wide: Banks 5 Year Senior Unsecured Credit Spreads, March 8 2023, April 25, 2023