Large banks relative winners

Large banks1 have been relative beneficiaries of the recent sector turmoil, as was highlighted in their recent 1Q23 results. This trend was most evident in JP Morgan’s results which came in ahead of expectations and included a high level of profitability (18% return on equity) and a 10% upgrade to their 2023 net interest income (NII) guidance, the only US bank to raise NII guidance. The difference between their average (-3% quarter on quarter) and period-end deposit data (2% q/q) also demonstrated that JP Morgan was a clear beneficiary of the reallocation of deposits following the Silicon Valley Bank crisis.

Deposit trends stabilising

US bank deposits fell $350bn (-2%) in the three-week period in March following the failures of Silicon Valley Bank (SVB) and Signature Bank, with small bank2 deposits contracting 5% q/q, compared to large and mid-cap banks’ deposits contracting 1% and 2% respectively. However, subsequent Federal Reserve data suggests actions taken by the regulator have stabilised the situation – small bank deposits fell 0.3% week on week in the second week of April, broadly in line with average seasonal trends, with managements noting that elevated outflows lasted only a few days during the SVB crisis. Western Alliance and PacWest Bancorp, both in the eye of the storm as small-cap banks with technology exposure, noted that deposit outflows stopped on 20 March and have grown $2bn (4%) and $1.8bn (6%) respectively since quarter end.

Source: Company reports 1Q23.


Higher funding costs to weigh on net interest margins

The increase in funding costs accelerated during the quarter with small banks seeing the largest rise, reflected in net interest margin compression of 13bps – compared to -2bps for mid-sized banks3 while large banks saw margins expand 7bps – as funding costs rose 47bps q/q (large banks saw a rise of 34bps q/q). The shift in deposit mix away from non-interest-bearing accounts is a headwind for NIMs and is most evident at the smaller banks (non-interest bearing deposits -370bps q/q to 37% of total deposits; large banks -50bps q/q to 28%). We expect this funding cost differential between small and large banks to be increasingly evident in subsequent quarters, reflecting a further shift in deposit mix.

No change (yet) in asset quality

The quarter showed resilient asset quality trends with minimal changes in non-performing loan ratios across large and small banks. Uncertainty as to the extent to which asset quality will deteriorate from here remains a key overhang on the sector, with commercial real estate (CRE) in particular focus. Feedback from management points to the potential for deterioration in CRE asset quality over time as loans come due for maturity. However, it is important to note the difference in CRE exposure in terms of underlying properties with multi-family apartment blocks and warehouse exposures considered more resilient while office and retail remain under pressure.

Source: Company reports 1Q23.


Regulation to be harmonised

US bank capital ratios remain healthy against current requirements, however regulations are set to be tightened as regulators assess recent bank failures and propose changes. Michael Barr, the Federal Reserve’s vice chair on supervision, published his report on 30 April which called for lowering the threshold for greater regulatory scrutiny from $250bn in assets to $100bn. It also highlighted plans to increase liquidity requirements and ask banks to include unrealised losses on certain securities in capital ratio calculations. Positively, the reported stressed that the proposed rulemaking will not be rushed and instead will follow the normal multi-year process of phasing in the new requirements, ie allowing an orderly transition for those affected and significantly reducing the risk of forced capital raises. Nonetheless, as the largest banks already comply with stringent liquidity requirements and include unrealised losses in their capital ratios, the cost of increased regulatory burden will be felt most by small and mid-sized banks.

Fund positioning

Our financials portfolios had already seen a material reduction in US bank exposure over the past year (-16% and -15% in Polar Capital Global Financials Trust (PCFT) and the Polar Capital Financial Opportunities Fund respectively) and most of that was in the US small and mid-sized banks (an 18% and 17% reduction respectively) on the expectation that the rise in margins from higher rates was reaching a peak. While we currently have no small bank exposure in PCFT and <1% in the Financial Opportunities Fund, our analysis suggests small bank valuations are already pricing in both lower interest rates and a weaker asset quality environment. As an example, adjusting Western Alliance's revenues for the forward rate curve, its valuation implies non-performing loans at 2.9% of its loan book (all other things being equal), compared to 0.25% reported in Q1 2023 and a peak of 1.8% over the past 10 years. Consequently, we see strong recovery potential in high quality, relationship-based smaller banks (that will use the current turmoil to take market share and reinforce their competitive position) but are sitting on the sidelines until there is greater visibility on regulatory changes and asset quality.

Source: Bloomberg; 26 March 2023.


1. ‘Large’ refers to JP Morgan, Bank of America, Citigroup, Wells Fargo.

2. ‘Small’ refers to East West Bancorp, Western Alliance Bancorp, Comerica, Webster Financial Corp, Zions Bancorp. These have reported 1Q23 results and we feel are representative of small-cap banks.

3. ‘Mid-sized’ refers to PNC Financial Services, US Bancorp, Truist Financial Corp, Fifth Third Bancorp, M&T Bank, Regions Financial Corp, KeyCorp, Citizen Financial Group.