Regional Banks Are Marching Onward

Since Silicon Valley Bank and Signature Bank’s March failures triggered a regional bank panic, investors have awaited the answer to one big question: Would smaller banks lose their low-cost funding base, jeopardizing lending? Fed data showed total small banks’ deposits holding steady as spring warmed to summer, and their loan growth—though slower—is still in double digits year-over-year.^[i] But we still didn’t know how much more banks were having to pay depositors to stay and how that was affecting profits. Until now: US regional banks reported earnings last week, and the results were encouraging enough to help regional bank stocks continue their nascent recovery. Nothing here is forward-looking, but the results show broad markets were correct to move on quickly.

Over two dozen regional banks reported Q2 earnings last week, giving a pretty representative sample of how the industry is coping. Overall, the results were a mixed bag. Net interest margins (NIMs, the profit margins on new loans) fell at all but 2 of the 25 noteworthy banks to report, with the drops ranging from 4 basis points (bps, or 0.04 percentage point) to 64 versus Q1 2023.^[ii] That left NIMs ranging between 2.12% and 4.28%.^[iii] There is a lot of variance in between, but the average drop was 18 bps to an average margin of 3.43%.^[iv] Companies reported that the migration of deposits to larger institutions and money market funds is showing signs of stabilizing, but most banks are using wholesale deposits to cushion retail deposit outflows and bolster liquidity. Those are more expensive than retail deposits, leading banks’ funding costs to rise more than loan rates—hence the drop in NIMs. Banks expect these trends to linger through the rest of the year.

So, not great. But also, not nearly as bad as feared—a stark reminder that the gap between reality and expectations matters most. When investors expect disaster, and reality is just kind of bad instead, that qualifies as a positive surprise. In this case, even lackluster results and lower guidance were a relief. A slow deposit trickle isn’t a systemic run. Modestly weaker NIMs are a far cry from the cascade of failures everyone feared in March. The industry is clawing its way through.

Here is another encouraging tidbit: Commercial real estate still isn’t destroying regional banks’ balance sheets, defying widespread fears to the contrary. Banks are provisioning more for potential losses, which is consistent with accounting rules requiring banks to set aside funds well in advance, but there are no apparent signs of a major credit deterioration—non-performing loan ratios actually ticked down at several banks. In our view, this is all pretty consistent with the fact that most commercial real estate exposure is in multifamily properties, not the much-maligned office sector, with a relatively small amount of loans maturing in the next year or two. The latest earnings reports are another sign this fear is false.

Earnings reports reflect what already happened—not what is to come—so we don’t see any of these results as predictive for stocks. Instead, we think they flesh out what markets have already priced in—in this case, that the risk of contagion from Silicon Valley bank was quite overstated. When markets start bouncing before the headlines calm, it can easily seem irrational. But in this case—and as is typical when fear runs ahead of reality—it was simply markets pricing in the damage and moving on. It is one of the most efficient processes on the planet.

Hat tip: Fisher Investments Research Analyst Patricia Shin