Street Talk | Episode 124: KBW CEO challenges investors painting banks with broad brush

Table of Contents

Call Participants.............................................................................................................. 3

Presentation.................................................................................................................... 4

Question and Answer...................................................................................................... 5

Call Participants

ATTENDEES

Nathan Stovall

Thomas Michaud

Unknown Speaker

Presentation

Unknown Speaker

Welcome to Street Talk, S&P Global Market Intelligence's podcast that offers listeners a deep dive into issues facing financial institutions and the investment community.

Nathan Stovall

I'm Nathan Stovall, and on this episode, we're looking back at the banking industry in the 12 months since the liquidity crunch of 2023. And we're talking about what has changed, how banks have changed their positioning, what their balance sheets look like, and importantly, how do regulators and investors view the sector a year later now that the dust has settled?

Coming back on the show to offer his view on the lasting impacts and his view of the sector, that's the part we're perhaps most interested in, is KBW's CEO, Tom Michaud. Tom, thanks so much for coming back.

Thomas Michaud

Nathan, great to be with you, and I look forward to today's discussion.

Question and Answer

Nathan Stovall

So Tom, let's look back for the past year. What do you see are the big lasting impact, maybe lessons learned? How do you look at banks today from a positioning standpoint? And how does it compare from a year ago?

Thomas Michaud

So a couple of things. One is while 3 medium-sized to larger banks did fail and they failed rather spectacularly, and unfortunately, I think it's 2 things. One is understanding what happened there, number one. And then number two, don't forget 4,700 banks didn't fail, did manage their way through that period.

So sometimes I feel as if the ones that got off base become the center of all the conversation, you kind of missed where the majority of the action really is. With regards to the 3 banks that failed and the lessons learned, I had a chance to testify in front of Congress for the reasons on the failure and policy recommendations to do about it.

In preparation to that, I had a chance to read through all the FDIC failure follow-up reports, which I thought were really well written. They had a lot of information in there that I didn't know previously. I started my career as a bank credit analyst for a division we had called Bank Watch. So really being a credit analyst where I started and learned the analysis business in my career in here at KBW.

And I looked at it, and it looked to me like many of the golden rules of bank credit analysis were filed, meaning when I saw that Silicon Valley Bank had $13 billion in their top 10 deposit relationships with almost all of that uninsured really startled me. I mean that was staggering to see. So that was really one.

Number two is concentration is a higher risk thing to do. And when you look at the concentration of deposits, concentration of industry segment, concentration of individual relationships that rolled up to one venture capital firm. And you see all that. You see that it just really was not a fully distributed client base and that there really could be some pro-cyclical nature as what could happen.

And the other takeaway, there were plenty of early warning signs that were not adhered to. At Silicon Valley, I think it was 39 MRAs that hadn't been addressed. Didn't have a Chief Risk Officer for almost a year. At First Republic, there's a story in there about how their dashboard or risk sensitivity started to blink red in the second quarter of 2022.

And the Board's reaction to that was, management's going to monitor. And then it happened again in the third quarter, and the answer was management's going to monitor. Other takeaways of all this is that the idea to that held-to-maturity accounting would be the safe harbor during the entire period was a key assumption that turned out to be unfortunate.

I believe the run at Silicon Valley Bank started because the depositors got more nervous than the rating agencies and the regulators, which was interesting, and that was the risk, and the risk there was you don't have bank lines and branches really, even though there were some. This was all electronic and it was all overnight. So this was just different.

But these were some of the guardrails of what I'm aware of, which are just good, sound banking practices that kind of got off base. And by the way, the policy response has been more capital, okay? The reality is these banks were well capitalized. The shocker, its First Republic Bank was upgraded to a 1 rating for liquidity right before -- not right before, but the last rating change was to a 1 before they failed.

It tells you that the old regime of analyzing these companies has changed and that supervision needs to adapt to the new world and just coming with a rules-based approach alone is not the answer. And raising all the capital ratios and gold plating it to the degree that it's been done, I think, is overreach.

And if you want to know what overreach may look like, we have an example. Go to the mortgage market, where going into the global financial crisis, banks generally made 90% of the mortgages in America, residential. Today, it's 20% and declining. It's not that banks don't want to make mortgages.

It's not that they don't realize that a home mortgage is a central part of a typical retail customer's financial life, it's that there are other reasons why they're not in that business like they used to be. And I believe it's because of the capital rules changes for mortgage servicing rights, which is where really a lot of the economic value lives, it's for the fact that if you're a bank, you have multiple regulators in the business that nonbanks don't have.

That's a competitive advantage for non-bank. CFPB does regulate everybody. But those are some of the examples of what happens over a decade or more when regulation changes. So don't think that these rules today won't have an implication on the industry for the next decade.

Nathan Stovall

I want to pick up on that, too. And I heard you speak at Acquire or Be Acquired and you almost made the same point, yes, I heard you going there of what kind of financial services industry do we want? I feel like you were just kind of saying, and I remember you saying that's a great point, that they aren't necessarily thinking about it holistically because that is what is happening here, right?

You've got all different kinds of industries coming. And I love the slide you had about the changes in market share or the mortgage market share that you just alluded to as well. I mean that really is striking when you see those 2 things side-by-side over a 15-year period.

Thomas Michaud

And a part of the more recent proposal is that the banking regulators want to give an operating capital charge for non-balance sheet business. When I see that, it reminds me that during the global financial crisis, the leading American investment banks were encouraged one night to become banks. Now they're going to come with a tremendous amount of capital charges on those very banks and the outcome could be they need to get rid of their investment banks.

So we'll go right back to where we were last time and we'll have done a complete circle with government regulation. So which one is it? My view would be, we're at a stage where we really need to focus on what's the regulation that we need, we ought to have, across the entire financial services spectrum? And not just pick individual slices of it, whether it's banks, insurance companies or any, you've got multiple different regulators headed in different directions.

It wouldn't be bad if we had a coordinated approach across the whole sector. Otherwise, the industry is going to look a lot different in 10 and 20 years from now, in my opinion. But let me also talk about one other point, which is, I do believe the AOCI in the mark-to-market issue of it being exempt for regulatory capital ratios should be changed from what it was before last spring.

Meaning mark-to-market probably should be pushed down into the banking industry more because I think if it had been, you probably wouldn't have had the duration in some of those assets that you have. So I think that actually was a smart fix, and I think that's worthwhile doing. The capital ratios, whether it's Basel III or how heavy crossing $100 billion is.

I will highlight to you that some of the public statements by bank CEOs that the annual cost of being a $100 billion bank could be $125 million. If that's the case, I can guarantee there will be no $101 billion banks in America. They're either going to not cross $100 billion or they're going to hurl themselves across $100 billion to pay for the $125 million.

Nathan Stovall

And that's what, 15 bps off their ROA, right there, basically. I mean that's a significant marker.

Thomas Michaud

Our research has been tracking these stocks and factoring in the cost and normalizing an earnings model. And you could see there's a 100 to 200 basis point dip in return on capital and investors are going to factor that into stock prices, and it's already started.

So these actions have -- if the goal is to do that, I'd love to have an overarching policy statement for why it was done. Is it to remove risk from a banking system, which it might be? Or is it do we want fewer banks or we want more activity in nonbanks because we think it's getting it away from deposits and will have less depositor risk. Whatever it is, I think that the policymakers should cite what the ultimate goal is.

Nathan Stovall

Two things I want to pick up on that you were talking about that were really interesting from the failures are concentration, that's an old idea. It's been around a long time, and having triggers on your risk policy being hit and not enforcing them. The reason I come back to them is both are things that are pretty old school in banking. I mean was that kind of the point you're making? We don't need to necessarily rethink this.

Thomas Michaud

100%. And then I'll even throw in -- there's another convention I realized I say, just growth. Silicon Valley Bank grew 85% in the year organically. That never happens. If you think about it, banks kind of grow as fast as GDP plus something if they're taking market share, that was unusual. And I think the reminder, the new reminder here is, banks typically don't grow that fast. And if they do, there should be further examination about what's happened.

Nathan Stovall

Right. If you're outgrowing your market, you're taking risk somehow. I remember somebody told me that a long time ago when I first started following this business.

Thomas Michaud

Yes. But it's not like -- let's say, your market is growing 4% and you grew 6%. That's not the issue. The issue is your market is growing a few percentage points, but you grow 85%. That's a little [ wrecked ].

Nathan Stovall

You spoke to this earlier as well, the impact of regulation, the impact on return and how it could negatively impact valuation, and you're already seeing it, and you've highlighted in the firm's research has highlighted that it's already negatively impacting valuations. What difference are you seeing there? Are you seeing lines of the $100 million mark? Are you seeing it in different places? Because coming out of GFC, you wanted to be kind of that [ 5, 10 ] range. And now I feel like it's totally flipped.

Thomas Michaud

We wrote a report that I think is going to go down as one of our seminal research report. We call it Chutes and Ladders. You remember that childhood game we all play, which is you kind of climb up the ladder until you hit the chute, you go backwards a little bit. Well, that's what happens, we think, to the profitability in the banking industry to approach a regulatory threshold.

It could happen at 10 billion. It could happen at 100 billion. It could happen at 250 billion as you keep hitting these major thresholds. But one of the bigger chutes now is at 100 billion. And so that's going to have implications of what the industry looks like because the management teams and the boards of these companies have to factor that into their plan. And again, it just adds a different degree of impact what the industry looks like.

And I think it ultimately could have an impact on availability of credit, which is what I think policymakers should want for small business because I think the banking industry is breaking into 3 segments. We've got the Top 25, which is really the Top 4 dominate the Top 25. But the Top 25, they've got 2/3 of the deposits in America. You've got 10 billion and under, where 97% of the banks are and 97% of any number is almost all of it.

And then you've got the middle part, the midsized banks where they're a little bit more than 100. I think those mid-sized bank are some of the gems of our economy that not every nation has. And they tend to be more small business-focused, and they're the ones who could really benefit, I believe, from FDIC and churn because what we saw in the last crisis is that small businesses got worried fast, and they started to try to move the bulge-bracket, Top 25 universal banks.

We don't want to be in a position where America picks their bank based on its asset size every time there's a price. That would be bad. And that's the reason why the FDIC was created to begin. Interestingly, you can go to the FDIC website. Last time I was there, they had FDR's speech or part of it. Because listen to him tell you why you need an FDIC.

So we need it. We just need to modernize it for modern times. And I think the way to do that is by raising the limit for payroll accounts, which are transaction accounts. And if they need to be noninterest-bearing to try to offset the moral hazard argument, so be it.

But that's what we should do because by the way, don't think big is always safer because the biggest bank failure in the last year is Credit Suisse, which it didn't technically fail. They did decide to sell to a 100-year competitor across the street over a weekend with government intervention, I assume.

They needed a partner and they were a global city. They're one of the biggest banks in the world, yet they needed a solution. So the point is, big doesn't mean better, but big might mean too big to fail, and that has to be neutral. And the FDIC, to their credit, wrote a very good report about the options for policymakers and there's one called the targeted approach.

I would be all in on that and raise that to $10 million. You don't take a lot of risk to do that, and it could even be noninterest-bearing, which would offset the moral hazard argument. The other thing that should happen is banks should be allowed to purchase additional insurance for their customers. which they're already doing being via these electronic platforms. So that risk is already in the system, but you probably don't need the intermediary.

You should be able to have the FDIC fund, have it available if someone wants to purchase it. So if you're a smaller bank and you want to bring on board a commercial customer who wants that security, you can have them embedded into the price range.

Nathan Stovall

We had it with the TAG program, right? We had this program coming out of the financial crisis. We utilized it. It went away because it was temporary, but there's a model for it, right?

Thomas Michaud

Yes. And my view is that that's a small business thing, because passive America's jobs are in small businesses. And remember, when the PPP program came out during the pandemic and the government wanted relief in small businesses' hands fast, 55% of that relief went through regional and community banks.

They don't have 55% of the deposits in America, but they're the ones who are connected with these small businesses. And a lot of it are these midsized banks and you need them there to serve small business to grow the economy. I mean, that to me, that's how the dominoes stack up or why it's a good decision.

And I don't think it's a dangerous decision. No one's saying ensure all the deposits. If you combine it with strong supervision, I don't think the fund is taking much more aggressive than it is now.

Nathan Stovall

Absolutely. And you're not the only one making that case and I think it's very logical. You spent a lot of time, aside for the regulatory side, you spent a lot of time talking with investors. We saw the group obviously rally off of the lows in the summer of '23.

And then we've kind of come back to a little bit of a holding pattern here. CRE, being the thing we probably hear too much about without enough nuance there. What is on investors' minds? Are they concerned? Do you think there's not enough nuance in some of those conversations? What's your view?

Thomas Michaud

And I got to tell you, I think there's a giant paint brush that paints the whole industry at the same time. Incredible. The other day, when [ DR Communities ] was halted at the time they were going to announce the recap, I was watching the BKX and the KRX. The KRX or [ Keith ] Regional Bank Index was dropping.

And it's because when there's a problem in the industry, all the banks seem to be put in the same bucket, whereas if you really peel it back, we research over 200 of them. They're not all the same. I think number one is that's the opportunity when that happens because you can buy shares that are being impacted that they don't have the same risk, number one.

But number two is it doesn't affect the investor psychology, which is until we probably feel like we get more of an all clear signal for commercial real estate, it's hard to think that the group is going to have a really big route. And the danger, I think, from commercial real estate is not that it's an industry stability issue, it's an earnings issue. And we've got, in our industry models for this year, 26 basis points provision.

That probably still is below average for a cycle. So if we do start to get commercial real estate losses, even if it's not going to impact book value or profitability, these banks can still be profitable, but your earnings estimate could come at risk. So I think it's more of an earnings estimate confidence issue while we've got this commercial real estate issue out there.

But then we can unpack commercial real estate. It's a huge category, big asset class. There are slivers where the risk is greatest. Typically, large office building, urban centers, typically coastal. If you want to look at what that looks like, Wells Fargo produces that information in their earnings, they've got 10.5% reserve against that type of portfolio.

The reality is losses in the global financial crisis in that category weren't 10.5%. So you'd like to think they've just built a fortress reserve. So that's one area of concern. The other areas or anything that's been rent controlled, and I could go into the dynamics if you wanted to go deeper about why rent control buildings have been under so much pressure.

I think another issue is seasonality, meaning loans made in 2020 and 2021 when interest rates were 0, are likely to adjust. And are those borrowers going to be ready for current market rates, and that's frankly in every asset class. And that's something we'll be talking about, and that could be a headwind to the economy. But again, bankers know this. They're out in front of it. They're restructuring. They're asking borrowers for more equity.

So I think for all those reasons, it could be an earnings issue, but I don't think it's a big solvency issue for the industry. Then there are some banks that just don't have any exposure in that. I keep using the Montana Bank. I think the Montana Bank is a good bank.

They don't make a lot of San Francisco and New York City, downtown large office building. They just don't do it. So when you see those -- and then you look at dividend yields, one of our favorite stocks is Truist. You get a 5-plus percent dividend yield. I believe the next time that dividend changes, it's going up, not down. And these are really good -- and the bigger banks, I should give you another sliver here.

The bigger banks have less commercial real estate. We do favor the bigger banks to the smaller banks at the moment because we think they have less earnings risk because they tend to have more liquidity and less commercial real estate, and they do have the benefit of scale. So if you were to look at our ratings, 4 of our favorite ideas are the largest bank.

Nathan Stovall

And investors have gravitated towards there with that idea as well. And I happen to be -- I've made the same case that you just made to a number of people, so I'm happy to hear that I'm in good company. But it is an earnings issue, not a safety and soundness issue.

Well, in closing, you spoke to this, what's the catalyst for the group and investors? I mean, I think some of it is just time. It feels like this is going to take a while because that's just sort of how this credit stuff plays out. It's not a 1-month event.

What do you see? I mean, you obviously talked about some disconnect, broad brush, so there could be opportunities today, but what kind of gets people excited, do you think?

Thomas Michaud

Well, the rally that we got off of the end of October was really around the Fed pivot. So the Fed pivot was the Fed is not going to keep raising rates, likely to cut rates. So the bond portfolios for banks and the pressure on credit is going to be less. And for those 2 reasons, you could take the worst-case scenario off the table. So all we needed was the worst case scenario that did not happen.

That was the 35% move from the end of October to the end of the year. I think that was the rally you were alluding to earlier in our chat. I think what it's going to take is it's hard to -- because investors are nervous about credit, and the only way to prove it wrong is to report your earnings to not have a big credit problem? And remember, too, CECL has required the provisioning upfront.

So that's going to be a little tip. We're all in a little bit of a new world with the accounting for reserves. My view is at some point, a light will go off. It will probably be where there's a macro opinion that the economy is not going to have a hard landing that we were further beyond the COVID moment and that the earnings estimates for banks are more rock solid.

When you get the rock solid feeling in earnings estimates, I think that could be when they start to move. And for some of the biggest banks, too, investment banking as a business line has been really weak. And we've been recommending some of those stocks because we believe there's a turn that's likely to come.

Every time in history, there's been a turn. And when it happens, it doesn't happen in a small manner, it tends to be quite robust. So investors have already started positioning themselves for that. So if you start to get revenue improvement because the margins get better, noninterest revenue gets better, credit is not falling off the table. If the market believed all that, these stocks are a discount and they're going to outperform. It's timing. I don't know when.

Now by the way, we may still get some accidents. I mean there may still be individual banks to get offsides on something, just like New York Community just did. It won't be perfect for every bank, but I think the industry overall and the typical bank, that moment will come.

Nathan Stovall

Well, terrific. Well, I think it's a great place for us to leave it. Tom, thank you so much.

Thomas Michaud

Nathan, great to be with you.