At least some amount of the stock pressure can be attributed to short-selling by long/short hedge funds. (UBS)

The Fed’s main role, in addition to monetary policy, is bank supervision—to ensure the safety and soundness of the banking system on behalf of depositors. The three midsize regional bank insolvencies since early March—as well as the subsequent attempts by the Federal Deposit Insurance Corporation (FDIC), the Fed, and the Treasury to shore up confidence—reflect glaring oversight failures, in our view.

So, what could calm investor and depositor nerves?

1. The passage of time. 1Q23 results and subsequent reporting suggest that deposit flows and Bank Term Funding Program/discount window borrowings have stabilized. Both PacWest and Western Alliance have reported that they’ve experienced deposit increases in recent weeks.

2. An expansion of FDIC insurance coverage. While the FDIC seems willing to declare failed US banks as systemically important and therefore guarantee their uninsured deposits, perhaps a blanket (explicit) guarantee of all deposits would help. This would require an Act of Congress, so we think a "tiering" of FDIC coverage is probably more viable.

3. Short-selling ban on select banks. At least some amount of the stock pressure can be attributed to short-selling by long/short hedge funds, in our view. One proposed solution would therefore be to impose a short-selling ban on select banks. This happened during the 2008 financial crisis, but it would be a temporary fix and would likely be disruptive to hedge funds’ long/short balance and could negatively impact volumes.

4. Some version of federal capital injection. During the financial crisis, the Troubled Asset Relief Program (TARP) forced all banks to accept a capital infusion from the federal government. It could reinforce industry capital adequacy; however, it would not likely be good for common shareholders.

5. Proactive M&A. So far, we have not seen buyers willing to step in without FDIC backing. Since regional banks investments/loans are mostly underwater, the amount and value of capital impact under merger accounting is uncertain.

Things seemed to calm a bit on Friday, with bank stocks trading a bit higher ahead of broader market gains. So, maybe the “bazooka” policy/regulatory measures won’t be necessary.

Nevertheless, we believe fundamentals remain challenging for the banks due to rate risk, credit risk, and capital risk.

There are some industry conferences scheduled over the next few weeks, and we expect managements’ commentary around liquidity and capital to be soothing (similar to 1Q23 conference calls), but we do not see many positive catalysts ahead. In particular, we expect a lot of noise and potential speculation about: 1) further tightening of lending standards due to rising funding cost (the Senior Loan Officer Opinion Survey of bank lending is due on Monday); and 2) tighter regulatory oversight of all banks (especially mid-sized regionals) around the 2023 stress test (DFAST/CCAR).

We remain neutral on the banks subsector, with a preference for large universal banks relative to regionals.

Main contributor: Bradley Ball, CIO Equity Strategist, US Financials

Content is a product of the Chief Investment Office (CIO).

Original report - Breaking the negative feedback loop in regional bank stocks , 5 May, 2023.

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