Banking on Opportunity

In 2023, the Fed’s rapid rate hikes challenged the banking sector, stoking increased competition for deposits, paper losses in securities portfolios, and ultimately the failure of several regional banks. And those were just the latest wrinkles. Increasingly, banks have had to contend with a changing regulatory landscape, which has created its own set of demands.

To adapt, many banks are adjusting their balance sheets, their lending practices—and in some cases, their business models. As a result, significant opportunities have emerged in private credit investing. It’s also raised questions about whether bank stocks are a good buy right now.

How Did We Get Here?

As interest rates skyrocketed last year, deposits fled, particularly from non-systemically important banks. Mid-sized regional banks were hit hardest as yield-sensitive depositors quickly shifted large volumes of assets to money market funds or the safety of larger institutions.

Compounding the issue, many banks had invested a portion of their deposits in low-yielding mortgages and Treasuries, whose value dropped as interest rates rose. While these losses have not been realized for the most part, marking them to market has hurt tangible book value (Display). What’s more, the funds tied up in lower-yielding assets are creating a profitability hurdle in today’s higher interest rate environment.

Amid tighter lending standards and a dwindling appetite to extend credit, loan growth in the banking sector—across commercial, real estate, and consumer loans—has slowed dramatically (Display). It’s a pattern that could prove auspicious for private credit investing.

Stricter Regulatory Capital Requirements Loom

In both the US and Europe, banks also face supervisory headwinds that will impact lending profitability and force many institutions to rethink their balance sheets. Proposed regulatory regimes—known as Basel III Endgame and Basel IV—would increase capital requirements, particularly for riskier assets. This could spark a shift in business models away from lending (Display).

Basel III Endgame would also change the way many banks account for unrealized losses. Currently, only the largest US banks, labeled “Globally Systemically Important Banks,” are required to reflect such losses in their regulatory capital ratios. Going forward, all banks with more than $100 billion in assets must meet this requirement. That includes larger regional banks, though the smallest institutions, like community banks, would remain exempt.

Bank Disintermediation: Filling the Credit Vacuum

As banks limit credit and improve their capital and liquidity positions, private lenders have a number of opportunities to step in.

• Asset Purchases: As they prioritize liquidity and capital, many banks have become highly motivated loan sellers. Private lenders can potentially generate outsized returns by acquiring these assets at discounted prices and, in many cases, with favorable terms.
• Capital Solutions: Some banks may prefer to hold onto these assets and collect income. Private lenders can facilitate this by improving the asset’s impact on bank capital through credit risk sharing.   
• Future Flow: Despite having limited funds to lend, banks still face ongoing demand for loans. Partnering with private lenders allows banks to maintain customer relationships and collect origination fees while private capital funds the loans.

Ultimately, banks’ retreat has left a vacuum that private lenders can fill. Private lending has become an increasingly important source of capital—a trend we expect to intensify. For those considering private credit investing, higher rates of return are available today in several areas, including direct lending to middle market companies, lending against commercial real estate, and providing specialty finance solutions to both banks and borrowers.

Are Bank Stocks a Good Buy Right Now?

Given these developments, it would be easy to dismiss the entire banking industry. Indeed, many bank stocks performed poorly in 2023. However, the impact of today’s backdrop won’t be uniformly felt. Mid-sized regional banks saw the largest drop in deposits due to unrealized securities losses and uninsured deposits. However, deposits at the largest and smallest banks remained relatively stable. These uneven results still echo today as mid-sized banks bear the highest cost of funding their assets, while smaller banks enjoy lower funding costs and less deposit flight (Display).

Plus, while larger US banks must prepare for stricter capital requirements, smaller banks will likely remain exempt. As a result, community banks continue to grow profitably while primarily avoiding the struggles weighing down their larger peers.

Despite these advantages, community bank stock prices fell with the rest of the industry in 2023. And they haven’t recovered to the same degree that larger banks have. Generally, they trade at less than 1x tangible book value (Display). In our view, this creates an attractive opening to invest in small, well-run banks at historically low valuations. These banks should further benefit from regulatory dislocation and an ongoing secular wave of bank consolidation.

Disruption Spells Opportunity

Rising interest rates have tested much of the banking industry, creating significant opportunities for thoughtful investors to explore private credit investing. As banks grapple with deposit outflows and higher capital requirements, the door opens for private lenders to support banks—or disintermediate them by lending directly to needy borrowers. While equity markets continue to paint with a broad brush, investors can capitalize by focusing on better-positioned smaller banks with attractive valuations and stronger fundamental outlooks.