Why normal-for-longer interest rates could boost U.S. regional banks

A case in point was the Fed’s aggressive rate hikes in 1994. The period that followed extending into the next decade was a fruitful time to invest in bank stocks, as the Fed maintained a normalized rate range.¹ For example, the price-to-book ratio across the banking segment expanded from an equity trading multiple of less than 1.5x in 1994 to around 3.0x by 1998.² In fact, the banking sector as represented by the S&P Composite 1500 Banks Index generated a total return of over 49% from January 1995 to December 1997.²

Will returns be as robust following the latest rate-hiking cycle? There will certainly be differences, but there are many reasons to believe that a similar stretch of sustained strong performance may materialize.

Bank revenues are expected to move higher

Most banks are currently underearning, in our view. In 2023, following the Fed’s rapid increase in short-term rates, deposit costs rose faster than loan yields.³ This negatively affected profit margins and earnings as the cost of the banks’ liabilities increased more quickly than their earning assets; however, we believe this negative impact has nearly run its course, as deposit costs have stabilized. Even with rate cuts on the horizon, regional banks’ revenues appear to us to be poised to spring higher over the next few years as the banks have a significant amount of loans and securities set to reprice meaningfully higher. Coupled with an increased prospect of lower deposit costs, this creates a strong outlook for banks’ net interest revenue over the medium term, in our view.

The median bank has 45% of its loans at a fixed interest rate, meaning the interest rate is constant until maturity.⁴ Typically, these loans have a five-year maturity. As such, the portion of its loans that originated in the low-rate environment of 2020–2022 will mature and be replaced with loans at much higher rate levels over the next few years. We believe this could significantly boost revenues.

In addition, banks' securities portfolios are commonly four to five years in duration and comprise 10% to 20% of earnings assets.⁴ Similar to the loan portfolio growth that we expect banks will experience, institutions are likely to see revenue grow when these securities mature and are replaced with higher-yielding assets. In short, we believe that most bank revenues are at an inflection point and will move higher over the next few years, regardless of the timing and pace of Fed rate cuts. 

Lower valuations further enhance the return potential

Typically, when a company is underearning, its earnings multiple (price-to-earnings ratio) trades at a premium as investors expect a near-term recovery. This was observed during the period 2006 to 2014 surrounding the global financial crisis when banking stocks consistently traded above their long-term average compared with the earnings multiples seen across the broader market.⁵

However, this is currently not the case. Banks have recently traded at just over 50% of the broader market’s earnings multiple—well below their long-term average of 78%.⁵ This leaves significant room for valuation expansion as revenues move higher.

Even with the recent outperformance—which we believe may have been aided by the expectations of a Fed cut and the improving fundamentals evident in second-quarter earnings results—valuations have remained significantly discounted relative to the broader market. Specifically, regional banks recently traded at around 11.0x their 2025 forward price-to-earnings ratio compared with the broader U.S. market at 20.2x for 2025.⁵ We believe that the attractive relative valuation of banks coupled with expectations for double-digit earnings growth in 2025 and 2026 signal the potential for strong performance.

Could rate cuts spoil the opportunity?

We don’t think so. The market has reacted favorably toward U.S. regional banks following Chair Powell’s announcement that strongly suggested the likelihood of a rate cut at the Fed’s mid-September meeting. We believe that a monetary easing cycle may act as a catalyst that helps unlock value, as bank valuations have been hampered by investors’ concerns over the impact of the Fed’s aggressive tightening cycle. Over a 16-month period from March 2022 to July 2023, the Fed funds rate increased by over five percentage points to a target of 5.25% to 5.50%.³

If incoming data following rate cuts leads the Fed to reverse course and implement additional rate hikes, the resulting rise in deposit costs could lead to further erosion of banks’ net interest margins. In turn, any such policy reversal could also delay any revenue growth from the asset repricing that we’ve recently begun to see.

In addition, any further rate hikes could aggravate persistent fears about the health of the commercial real estate market. We believe that the apprehension surrounding commercial real estate risk on bank balance sheets has been overstated and somewhat disconnected from reality.

While banks do have exposure to commercial real estate, most underwriting to real estate property firms has had conservative loan-to-value ratios.⁶ Moreover, regional banks have minimal exposure to large office assets located in central business districts, where most of the risk lies in this asset class. In fact, in the second quarter of 2024, the median small and midsize bank experienced only nine basis points of net loan charge-offs—a historically low level.⁶ While there may be some credit losses, we don’t believe the issue is systemic. Additionally, banks have established substantial reserves to absorb potential loan losses.⁶ 

A brighter outlook for commercial real estate and bank valuations

The concerns over higher deposit costs and commercial real estate exposure are likely to be dampened given expectations of a mid-September rate cut, in our view. Lower borrowing costs for commercial real estate borrowers are likely to act as a catalyst to bank multiples as fears around their debt service burden subside. If we look back to mid-1995, when the Fed began pivoting toward monetary easing, it sparked a significant improvement in bank valuations. While we don’t know how the market will treat such a move in 2024, history tells us it is likely to benefit valuations.

1 U.S. Federal Reserve Bank of St. Louis, 8/30/24. 2 FactSet, 8/30/24. Price-to-book is the ratio of a stock’s price to its book value per share. The S&P Composite 1500 Index tracks the performance of 1,500 publicly traded large-, mid-, and small-cap companies in the United States. It is not possible to invest directly in an index. 3 U.S. Federal Reserve, 8/30/24. 4 Janney Montgomery Scott, 6/3/24. 5 FactSet, as of 5/3/24. Regional banks are represented by the S&P Regional Banks Select Industry Index, while the broader U.S. equity market is represented by S&P 500 Index. The S&P Regional Banks Select Industry Index tracks the performance of the regional banking segment of the broad U.S. equity market. The S&P 500 Index tracks the performance of 500 of the largest companies in the United States. It is not possible to directly invest in an index. The forward price-to-earnings (P/E) ratio is a stock valuation measure comparing the current share price of a stock with the underlying company’s estimated earnings per share over the next 12 months. 6 Keefe, Bruyette & Woods, as of 8/2/24. A loan-to-value ratio is a measure that lenders use to compare a loan amount to the value of the asset purchased with the loan. Net loan charge-offs are the value of loans and leases removed from an institution's financial books and charged against loss reserves. Basis points: One hundred basis points equals one percent.