The outlook for U.S. regional bank stocks took a dismal turn this week when the share price of First Republic Bank plummeted and dragged down other small lenders, suggesting the crisis that has ensnared the sector over the past month may not be over.
Still tempted by cheap stocks?
Rebounds are certainly possible. But smaller lenders are facing tougher regulatory scrutiny that will likely weigh on the sector, offering a reason to look beyond the allure of low valuations and perhaps focus on the risks.
The iShares U.S. Regional Banks ETF, an exchange-traded fund that provides a good snapshot of 35 different stocks – from relatively large regional banks, such as PNC Financial Services Inc. and U.S. Bancorp, to smaller players, such as Valley National and BOK Financial Corp. – has fallen 32 per cent since the start of March.
The decline has raised the fund’s dividend yield (based on 12-month trailing distributions) to 4.2 per cent, up from 3.1 per cent at the start of the year, even though the first-quarter distribution declined 21 per cent from a year ago.
At the same time, the fund’s price-to-book ratio has fallen to just one, compared with a loftier ratio of 3.8 for the S&P 500, suggesting bank stocks are trading at beaten-up valuations.
Most of the downturn among regional banks occurred after the failure of Silicon Valley Bank, the result of a lightning-fast run on its deposits that forced the tech lender to sell bonds at a steep loss. Signature Bank failed soon after.
After several weeks of calm, First Republic Bank announced with its quarterly financial results this week that about US$100-billion of its deposits had been withdrawn, raising doubts about the lender’s survival. Its share price has dropped 97 per cent since the start of the year.
Even at regional banks that aren’t facing such stark challenges, share prices are down substantially. U.S. Bancorp is down 21 per cent this year, and Fifth Third Bancorp is down 20 per cent and trading near two-and-a-half-year lows.
The bullish case largely rests on regulators containing the banking crisis and restoring confidence in smaller lenders. If that happens, deposits will stay put and share prices will recover.
Investors appear to be showing interest. The iShares U.S. Regional Banks ETF generally attracted trading volumes of less than 100,000 units a day before the banking crisis erupted in March.
Over the second half of the month, though, average daily trading volumes spiked to more than 1.8 million – 18 times the previous level of trading – and remained elevated in April.
Some nimble bargain hunters could be nursing gains. Western Alliance Bancorp’s share price, for example, has rebounded more than 40 per cent from its end-of-day low in March. U.S. Bancorp rallied 5.2 per cent on Friday alone.
But the risks associated with this bet may have less to do with the current crisis and more to do with the response to it.
“I think the acute liquidity crunch is behind us. I don’t think we’ll see that same dynamic play out,” Christopher Wolfe, head of North American banks for Fitch Ratings, the credit-rating agency, said in an interview.
But, he added, smaller banks will likely have to pay more for deposits, which will eat into their profitability at a time when the economy is weakening.
“It’s not a good mix,” Mr. Wolfe said.
Regulators, which may have ignored some risks within smaller lenders because those institutions did not pose a systemic risk to the financial system, will likely turn their attention toward improving oversight – and fast.
On Friday, the U.S. Federal Reserve released its review of the SVB failure, placing some of the blame on the bank’s management and board of directors for failing to manage risks. But the Fed also noted its own lapses.
“Following Silicon Valley Bank’s failure, we must strengthen the Federal Reserve’s supervision and regulation based on what we have learned,” Michael Barr, the Fed’s vice-chair for supervision, said in a statement.
Canadian regulators, too, are looking at tightening standards in the wake of SVB, perhaps by imposing higher minimum capital levels on Canadian lenders.
Tighter regulation could also weigh on bank profitability, as banks adhere to tougher capital requirements and face additional costs associated with compliance. Changes could hasten the pace of consolidation among U.S. regional banks, according to Mr. Wolfe.
The sector may well have hit its lows during the current crisis. The way back up, though, is far from clear.