Banking’s Business Model, Bad News Rising, and Banking Crisis

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Welcome market participants to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting #creditmarkets that we think you should know about. We’ve turned the corner into April; here’s hoping we can leave behind our #bankingcrisis, which is now being referred to as “March events.” I like that—let’s hope we don’t replace it with a bunch of “April events.”

This week, our 3 Things are:

1. Community and regional bank business model. We examine it.
2. Bad news rising. Is this now a trend?
3. Banking crisis. Jamie Dimon says it’s not over. We’ll have a look.

Alright, let’s dig a bit deeper.

Community and regional banks.

We are out this week with published research examining the business model of community and #regionalbanks. We have long held the belief that the model is sound, and that starts with its cost structure. On the back of government-backed deposit insurance and access to the #Federal Home Loan Bank advances, smaller bank funding could be just as cost-effective as that of the largest banks.

Meanwhile, noninterest expense efficiency for banks with at least $1 billion in assets was also comparable to that of larger banks, something that many are surprised to discover. Think about it this way: As banks grow larger, they are in more markets and offer more products. They become more complex, more costly to manage. So, the benefits of larger scale are often offset by the costs of increased complexity.

So, when we add it up, interest expense and noninterest expense, the cost structures of smaller banks can compare favorably with larger #banks. That means that smaller banks can price their products, both assets and liabilities, competitively with the larger banks. And that means smaller banks do not have to be subject to adverse selection when it comes to risks. Put another way, they do not have to reach for earnings. They do not have to compromise the risk/reward relationship when booking business. And all of this is born out in financial performance. Well-run smaller banks can be just as profitable through a cycle as larger banks.

This by no means is to say that all smaller banks are well-run. For ones that are, they take advantage of their local roots, market knowledge, and responsiveness. They deploy sensible growth strategies. They manage risks well and minimize risk concentrations. They stay on the right side of regulators and policymakers. Decentralized banking in the U.S. works. It helps to fuel the economic engine and innovation of a vibrant small to mid-sized business sector that accounts for half of the jobs in the U.S., and much of its #economicgrowth.

But there is a cost to the #economy of having to regulate and legislate for 4,000+ banks. There will be accidents. Learning from each “crisis” is essential, and that, in this case, has happened. We don’t think we will see another bank of consequence get out of balance to the extent Silicon Valley Bank did.

And it is essential that regulators and legislators keep up with the technological innovation/disruption that is taking place in banking. The speed at which information and misinformation can affect all banks’ brand equity and critical flows, the things on which the industry’s money multiplier rests, has changed dramatically over the past couple of decades. The events of this March are a good wake-up call. For more on this topic, pull up my piece on KBRA.com.

Alright, on to our second Thing—Bad news rising.

Not to sound like a petulant child who incessantly asks, “Are we there yet?” But lots of folks are asking, “Are we there yet?” The destination in question is the #recession. The answer is, we are getting closer.

The Fed has raised rates at the fastest pace since the 1980s, from 0% to 5%, while deploying quantitative tightening. Moreover, we are battling through financial instability that has banks tightening loan underwriting standards, which adds the equivalent of another two to three hikes. Housing is in a recession. Real wages have fallen now for 23 months in a row. Seeds of an oil shock have been planted. Consumer confidence surveys are in recession territory. Small business sentiment is in recession territory. CEOs overwhelmingly are bracing for recession. We’re now in an earnings recession. The yield curve has been inverted now for nine months, and futures markets are pricing in four cuts by year-end. Bloomberg Economics’ recession-probability model sees a 97% chance of recession happening as soon as July.

Now, I’m beginning to sound like that petulant child.

This week, both ISM surveys came in weak, the Manufacturing PMI plunging to levels exceeded in the last 20 years only by the worst points reached during COVID and the global financial crisis (GFC). Services PMI hung on to finish still in expansion territory, but it missed the estimate badly.

This is what you get when you tighten hard and fast. You get concern, and eventually, concern becomes fear. You get #financial system accidents. Hunkering down overtakes risk-taking.

Support for economic growth has been the consumer, spending all the while on the back of still extraordinary excess savings and the confidence that comes from knowing that jobs markets are tight. Excess savings are running down, especially among lower income cohorts. Then there is the jobs market. It feels like it, and maybe it alone, is propping up risk asset valuations. It is all that stands between the Fed and mission accomplished. It is a famously lagging indicator. We all see the layoff announcements, the surveys that suggest employers are growing more cautious. We’re waiting for it to crack. Eventually it has to; that’s the point of what the Fed is doing. We’re getting closer to that point.

Alright, on to our third Thing—The banking crisis.

As we rumble along through this #economic flight, on our way to some sort of landing, I know you know that you cannot lose sight of financial stability for reasons that are clear.

Credit conditions—the degree of fuel fed into the economy—depend on it. Put another way, in a contracting economy like the one we are in, financial stability or instability will be instrumental in determining whether:

• #Unemployment rises to 5% (that would be in a financially stable world) or 10% (the outcome in an unstable one)
• Corporate earnings contract 10% or 40%
• Recovery is scored in months or years

Much depends on financial stability. Obviously, we felt the effects of this firsthand in the “March events.”

Much has been made over Jamie Dimon’s comment, in his annual letter to JPMorgan Chase shareholders, that “the current crisis is not yet over.” That was written, we would guess, when we were in the thick of things, when the shock of the largest bank failures since Washington Mutual was still freshly felt, and contagion a possibility.

Today, the situation is off the boil. While constrained by the legislative process, Fed and Treasury officials have stabilized markets by stepping up to provide explicit and implicit support to bank funding. Now, thus far, settling down has not helped regional bank stocks from clawing back lost ground. The KBW Regional Banking Index is trading at or near its recent low, down 19% since March 8. How should we think about that?

To start, let’s look at the starting point for regional banks coming into the downturn. We’re coming off of an extraordinarily favorable past couple of years, with supercharged growth and very low bad debt costs. So, looking ahead, we should expect some correction in equity multiples. Growth slowdown, #margin pressure from the repricing of deposits, the prospect of rising loan loss provisions. There is no shortage of headwinds. Yet multiples are the lowest we’ve seen since the depths of the GFC: The forward price/book ratio for the index is down to 0.9x, compared to a median of 1.4x recorded over the past 10 years. Forward price/earnings has been cut in half to 8.1x from a 10-year median of 16.6x. So, there is concern out there among investors at least in terms of growth and margin.

But we think Mr. Dimon was more concerned about a regulatory framework that is no longer working well to enhance confidence in the banking system. And it’s one thing to be reflective on what needs improving coming out of a crisis. It’s another when the weaknesses are exposed coming into a downturn.

So, how much of this has bled into credit spreads? Plenty. Prior to March, banks had tightened in to 2 basis points (bp) through industrials; today they’re 30 bps back. That’s too cheap in our opinion, if you believe, as we do, that the worst has passed, especially for the largest banks.

So, there you have it, 3 Things in Credit:

1. Community and regional bank business model. It still makes sense.
2. Bad news rising. It has spread beyond interest-sensitive sectors.
3. Banking crisis. The worst has passed, but reform is needed.

As always, thanks for joining us. Don’t forget to check in on KBRA.com for our latest research, including my piece on regional and community banks’ business model, and our ratings reports. Enjoy the holiday weekend. See you next week.