Following the failures of three US regional banks, it's apparent that this category of banks will likely be remembered as the primary victims of the 2022–23 tightening cycle. Potential deposit flows from regional banks have led to significant pressure on the prices of the securities throughout their capital structure—stocks, bonds and preferreds—which creates an uncertain market message about the financial health of the impacted banks.
The three US regional banks that were placed into receivership had unique profiles related to their deposit franchises and loan books, in our view. We believe that no regional bank issuer in our preferred coverage has these same distinctive vulnerabilities, but with the crisis of confidence yet to be resolved, we have a more cautious view on these issuers.
The failure of First Republic Bank on 1 May has brought back to the forefront of investors’ minds the ease and speed with which depositors can pull their bank deposits. The convenience and efficiency of digital banking, as well as the speed and reach of digital communication and social media, may provide precipitating factors that can make bank runs more prevalent. The Fed’s report, published in the wake of the Silicon Valley Bank failure, stated that “the combination of social media, a highly networked and concentrated depositor base, and technology may have fundamentally changed the speed of bank runs.”
The market is concerned by how quickly deposits left the banks that failed. And even though there is no evidence that it is happening again to any specific bank currently, the mere fact that it can happen should continue to be a concern for investors. The main driver is investor psychology. A very low stock price can become both an indication and a cause of weak sentiment.
We think that the failure of a larger regional bank is low. However, their stock valuations may continue to trade as if the risk is high. If these fears and concerns are allowed to fester for an extended period, then the perception may become reality—in that depositors may become motivated to actually pull low-rate deposits, thereby putting more pressure on bank funding and profitability as banks are forced to borrow at higher rates from the Fed. Volatility could continue to flare up until a firewall is established between market pricing pressures and potential deposit flows. For more information see, “ Breaking the negative feedback loop in regional bank stocks,” by CIO banking analyst Brad Ball.
So in our base case, we do not expect major, regional, or super regional banks to fail, and certainly not any of the large money center banks. However, even though this is our base case expectation, the possibility of additional regional bank failures cannot be ruled out completely.
With this in mind, risk-averse investors who may no longer wish to tolerate these possibilities should consider limiting their exposure to regional bank preferreds. On the other hand, investors looking to get more yield may find pockets of opportunity from the largest regional and super regional banks.
This table lists the 23 US-based banks that were Fed stress-tested last year, along with the Fed’s category types (at the time). These four category types are generally based on total consolidated assets, and regulatory requirements differ for each category. Category I encompasses global systemically important banks (G-SIBs) while Category IV comprises smaller banks with at least USD 100bn of assets.
We originally highlighted this table in our 21 March update, “ Preferred stocks hit by banking sector turmoil,” while suggesting a focus on the larger banks. Among our research coverage universe of bank preferred issuers, preferreds from the larger, Category I institutions may offer greater price stability, along with yields of 6–7%. Additionally, most of these preferreds are trading at discounts to par and therefore offer price appreciation potential in the years ahead.
In our view, the risks for regional bank preferreds at present have risen to a level that is higher than historical norms. But with increased regulatory measures likely to eventually apply to banks with as low as USD 100bn in assets, we see a strong likelihood that the risks priced into US regional bank spreads today will subside. Over a longer period, we believe that US regional banks should provide a spread normalization trade—such was the case for the US G-SIBs, after the provisions of the Dodd-Frank legislation were most stringently applied to them after the 2008 global financial crisis. But until the weakest links are weeded out and new regulatory regimes are gradually implemented, we view certain preferred issues through a higher risk lens and move to the sidelines on select issues. Specifically, we are downgrading the preferreds from Category IV banks, while keeping the ratings on preferreds from the larger bank issuers unchanged.
For more, see More cautious on regional bank preferreds , 9 May 2023.
Content is a product of the Chief Investment Office (CIO).
Main contributors: Frank Sileo, Barry McAlinden