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Banks Are Back

March 21, 2019

Banks didn’t get the attention that they should have last year. By 2018, after a decade of punitive legislative and regulatory rules, banks were nearly strangled from doing even the simplest of things, including taking deposits and making loans.

A perfect example was the dramatic increase in capital requirements and the types of securities that could be counted and at what valuations. This meant that the cost of keeping capital drove up the overall cost of making loans and conducting other traditional banking operations.

They also included highly complex and costly stress-testing on a continuing basis to prove how they would fare under various market and economic conditions. This meant devoting armies of financial and accounting professionals—again adding to costs and driving down margins.

In addition, banks were restricted on shareholder rewards, including restrictions on dividends. This meant banks—even very healthy banks—that needed equity capital found the market less than enthused to be part of the shareholder makeup. Adding to the challenges were restrictions based on size of assets, so smaller regional banks were discouraged from merging with other banks to lessen administrative and other costs.

All of the above effectively drove up costs for generating revenues. This showed up in one of the most telling of ratios for banks—the efficiency ratio. The efficiency ratio measures the cost to earn each dollar of revenue. The higher the ratio, the higher the costs.

Before the 2007-2008 financial mess, good performing banks would have efficiency ratios in the 25% to 30% range. Those ratios subsequently soared to 60% to 70% or more, meaning that it took up to 70 cents to earn each dollar versus the pre-crash 30 cents or so.

Adding to the troubles were the sustained low interest rates. While stimulating for the general economy, for banks the low to near zero short-term interest rates and low intermediate interest rates meant that they had little room to price deposits against loans. This meant that banks’ net interest margins (NIM) were squeezed.

NIM measures the overall spread between the cost of funds through deposits and other means against the yield earned on assets, such as loans and other facilities. Banks saw NIM plummet, again weighing on overall profitability. One more reason that lending was all the more challenging to justify.

Reformation

The process of legislative and administrative regulatory reforms would take time. But they began to come into play slowly in 2017 and into 2018. Capital requirements were eased—particularly for regional and smaller banks. Compliance costs were reduced for regulations. And review of regulations was more codified and eased—providing more certainty for banks and lower costs for business and consumer business operations.

And regulations were also further eased for regional and smaller banks based on asset size. This made domestic banks more attractive for investors and also meant that they were able to merge with less threat of more regulation compared to their mega-global bank peers.

Then came the Tax Cuts and Jobs Act of 2017 (TCJA). This brought down the corporate tax rate for banks as well as for all corporations. This was a particular boon for domestic regional banks that were focused on the US market for their earnings. This meant their after-tax profitability was dramatically aided.

And now, on top of all that regulatory reformation, the Federal Reserve’s Open Market Committee (FOMC) has hit the pause button on rates and largely done the same on its bond portfolio. This again is only adding to the case for rising bank profits.

Two banks that you should be buying are both successful regional banks that are showing demonstrative improvement in net interest margins and efficiency ratios. And they are also building up their loan books and deposit bases that are driving profits and fueling rising dividends again.

The tell-tale sign is that the KBW Regional Bank Index is up strongly this year with plenty of room to perform. And my current favorite pair of banks—Citizens Financial Group (CFG) and Regions Financial (RF)—have either followed along or have done even better.

CFG is focused on the Northeastern and Midwestern US. It pays a nice 3.82% dividend, which has been hiked over the past year by 50%. RF operates primarily in the Southern US and pays a similar dividend of 3.84%, which again was upped by half in the past year alone.

Both should continue to perform well as banks benefit from the sturdy economy and regulatory reforms.

All My Best,

Neil George

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