INSIGHTS

On May 12, 2023

Thoughts on Regional Bank Stress

The recent failure of First Republic and absorption by JPMorgan Chase continued to promote concern about stability of the U.S. banking system. This concern was likely compounded by the Federal Reserve’s (Fed’s) decision to raise policy rates again on May 2 and the nonplussed tone regarding bank stress evident in the Fed Chair press conference following the policy rate announcement. The epicenter of concern may be that the Federal Deposit Insurance Corporation (FDIC) is limited to subsidizing rescue takeovers only after they have seized a failing bank (which wipes out equity holders). This can pose the risk that equity in other banks perceived to be weak may be prone to destabilizing drawdowns.

Super-Regional Large Cap Banks

• These constituents have risk-weighted assets more than $250 billion, but less than the $700 billion threshold to be considered a “systemically important bank.”
• Though frustrating, investors appear to be viewing banks that share a regulatory categorization uniformly, as opposed to focusing on bank-specific fundamentals.
• In this category, higher commercial deposit exposure and greater losses on securities portfolios are often realities that represent fundamental headwinds; however, many of these banks continued to have access to capital markets. We view continued capital market access as an important mechanism through which super-regional banks could have the ability to accrete incremental regulatory capital in response to future regulatory adjustments.
• Further, in our view, continued capital market access and resilient business models could help support dividend sustainability for select banks in this area.

Regional Small-Mid Capitalization Banks

• These constituents have risk-weighted assets of less than $250 billion and are subject to less stringent regulation (for the time being).
• In contrast to super-regional large cap banks, several banks in this category have generally participated in less of the drawdown of the KBW Bank Index. This performance difference is partly driven by lower commercial deposit exposure, security and loan portfolio differences, and alternative regulatory infrastructure.
• Continued capital market access is observed across several of these constituent banks, which we view as important for potential future required additions to regulatory capital and future dividend sustainability.

Regulatory Thoughts

• The Fed’s recently released review of the Silicon Valley Bank and Signature Bank failures sheds light on the irresponsible levels of risk-taking present within each of these organizations.
• Though some of the dynamics that caused Silicon Valley Bank and Signature Bank to fail (securities portfolio losses, commercial deposit exposure) are present across bank industry constituents, there are far more differences than similarities with the failed banks.
• Major recommendations of the review include more stringent oversight and severe consequences for lack of compliance with regulatory body remediation guidance, and a need to raise incremental capital to absorb losses and enhance liquidity. These changes are proposed to occur over an extended period, allowing banks to accrete capital over a timeframe that avoids compounding existing bank stress.

Bottom-Line Conclusions

Bahl & Gaynor understands the questions investors have regarding stability of the U.S. banking industry. However, remember that the equity performance of the industry has not behaved as if a market-clearing event has occurred, and capital market access remains present across many banks, which we view as an indicator of future dividend sustainability, and an enabler of future regulatory compliance.

For most active managers, including Bahl & Gaynor, identifying and reacting appropriately to periods of market stress is part of the value-add proposition offered to investors. While we recognize the weakness in this area can be frustrating, we continue to see opportunity in select banks, and believe continued exposure is warranted at this time. While there is a possible risk of a catastrophic bank industry deterioration, we don’t anticipate this outcome, which would be counter to the objectives of regulatory infrastructure established in the wake of the Global Financial Crisis and actions taken by policymakers to date.

CRN: 2023-0508-10868 R

Opinions in this piece are those of Bahl & Gaynor Investment Counsel and are not necessarily that of AAM.