Image Source: Carlssa Rogers
Structure of the Regional Banks/Asset Management Industry
The regional banking and asset management industry is based almost entirely on the confidence of intermediaries and counterparties that make up the building blocks of the financial system. An investment in a bank or asset management firm must come with the acknowledgement of the distinct possibility that another financial crisis may occur at an unknown time in the future. Though we don’t expect one anytime soon given the recent favorable stress-test results of the largest US banks, it’s worth noting that there have been three significant banking crises during the past three decades alone: the savings and loan crisis of the late 1980s/early 1990s; the fall of Long-Term Capital Management and the Russian/Asian financial crisis of the late 1990s; and the Great Recession of the last decade that not only toppled Lehman Brothers, Bear Stearns, Washington Mutual, and Wachovia but also caused the seizure of Indy Mac, Fannie Mae (FNMA) and Freddie Mac.
Though regional banks may avoid risky international lending, they are not shielded from potentially prohibitive funding costs and liquidity issues that plague certain investment securities during a crisis. Investors must pay particularly close attention to a bank’s capital position (Tier I capital), leverage (total assets divided by total equity, loans/deposits ratio) lending standards (loan loss provisions, non-performing loans), its growth plans (as this could lead to reckless risk taking), the general economic outlook for residential and commercial activity (especially housing and the mortgage markets), the interest rate environment, and the structure of the yield curve (net interest margins). In early December 2018, the yield curve was at its flattest point since 2007 as measured by the 2-year and 10-year yields.
Regional banks are also sensitive to the regional economies they serve, making them increasingly sensitive to the health of certain industries. For example, regional banks in Texas felt an outsize amount of fundamental weakness as a result of the collapse in energy resource pricing of the middle portion of this decade. On the other side of the coin, those more exposed to areas of the country that are expected to benefit from the Trump administration’s infrastructure-based stimulus plan could see an outsize boost in lending demand. Strengthening of corporate profitability and an increase in repatriated cash as a result of corporate tax reform could provide a step up in bank earnings as well.
An easing of Dodd-Frank regulations came in May 2018 as the threshold under which banks are deemed too big to fail was raised, also reducing the number of institutions that have to undergo ongoing stress tests. In addition, mortgage loan data reporting requirements were eased for the majority of banks, which should help community banks in the mortgage lending market, but may raise systematic credit risks. The recent political firestorm that has engulfed Washington D.C. has brought into question Trump’s potential to make good on economic stimulus promises, and trade tensions with major trading partners, namely China, further muddies the waters. Both conditions may impact the lending environment.
We generally prefer the oligopolistic structure of the Canadian (EWC) banking system relative to the highly fragmented and extremely competitive US landscape, but recent growth in consumer debt and concerns over a potential rapid cooling in the housing market in Canada have left many banks in the country vulnerable to potential losses, too. Canadian Imperial (CM), Royal Bank of Canada (RY), and Toronto-Dominion (TD) boast strong returns on equity thanks in part to the more favorable Canadian banking structure, but they are not immune to potential losses and weakening consumer confidence that can emanate from such losses. All things considered, absent significant changes to prohibitive global regulation and burdensome capital adequacy requirements, we don’t expect the regional banking industry to ever achieve the return performance of years ago, pre-Financial Crisis. It’s also worth noting that the elevated dividend yields of some industry constituents are more indicative of a higher risk profile than their attractiveness as an investment opportunity.
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Related ETFs: KRE, KBE