Banks at a Crossroad
BY VINCENT CUROTTO
On Weds. May 3, just hours after Jerome Powell assured the public that the U.S. banking sector was “sound and resilient,” reports that PacWest was “weighing strategic options” sent the bank’s stock down 50% in after-hours trading. This came on the heels of Tuesday’s rout in regional bank stocks and only days after banks reported relatively sanguine earnings.
The move in bank stocks underscores investor uneasiness and raises fears of a self-fulfilling death spiral reminiscent of the Global Financial Crisis. Banks need to raise capital, but the risk of shareholder dilution increases as bank stocks decline. In other words, as the value of each share decreases, more shares are needed to raise a given amount of capital. The risk of dilution forces more selling, which increases dilution, and so on. With the value of the regional bank index down ~40% since early March (as of May 4, 2022), the number of shares needed to recapitalize a bank has increased significantly.
Complicating matters, it remains unclear how much capital banks need to raise. Will banks need to raise enough capital to cover the embedded losses in their securities portfolios? While the amount of those losses is a relative gauge of a bank's capital needs, it’s unclear whether banks will need a full or partial recap of these losses. And what about potential credit losses in commercial real estate? While banks have avoided CRE losses to date, signs of impending stress are increasing.
Of course, filling holes in bank balance sheets isn’t the only need for capital. The regional banking sector faces long-term, secular challenges. It’s reasonable to assume that the regional banking model will undergo significant and permanent changes. For investors, this makes forecasting future bank earnings and valuation difficult until there’s more clarity around the current crisis's impact on regional banks' long-term business model.
As the crisis unfolds, the regulatory environment grows more opaque and volatile, yet more consequential to investing in banks. The regulatory fallout will almost certainly result in more oversight that will both directly and indirectly impact the banks’ bottom line. Once the dust settles and banks look to execute their long-term strategies, success will be largely determined by how well they navigate the regulatory minefield.
The bank crisis is far from over, as the market crudely reminded us this week. While it’s unclear how events will play out, capital raises are coming. Opportunities for investors to allocate capital in the long-term “winners” in banking will eventually emerge. Right now, however, it’s seemingly still too early for investors to pull the trigger.