Why some on Wall Street think the regional bank recovery can become a rebound in 2024

Published Wed, Dec 20 202312:05 PM ESTUpdated Wed, Dec 20 20231:12 PM EST

Jesse Pound @/in/jesse-pound @jesserpound

Roughly nine months after the rapid rise in interest rates helped topple several regional banks and sent the sector's stocks into a tailspin, the group is on the upswing and some on Wall Street see an even bigger comeback in the new year. The SPDR S & P Regional Banking ETF (KRE) closed Tuesday at $52.75 per share. That is down 10% for the year, but up 46% since its low point in early May. KRE YTD mountain This regional bank ETF is still down for the year despite a strong rally off its lows. The collapse of Silicon Valley Bank and some of its peers was caused by a combination of aggressive rate hikes from the Federal Reserve, customers pulling cash out of low-interest accounts and mismatches on the bank's balance sheet. Those trends appear to have slowed now, and the underperformance of regional bank stocks combined with a surprisingly strong U.S. economy could create an opportunity for a rebound. "The key industry issue in 2024, however, will be credit quality, in our view. Investors understand credit quality trumps all other fundamentals trends in banking," RBC Capital Markets analyst Gerard Cassidy said in a Dec. 14 note to clients. "The credit cycles of 1990 and 2008-09 were devastating to banks stocks and valuations as the industry experienced capital depreciation and dividend cuts and/or eliminations. We do not foresee this cycle being anything similar to 1990 or 2008-2009 due to a de-risking of the industry following the 2008-2009 Financial Crisis," Cassidy said. SVB Fallout The stabilization of the banking sector after the fall of SVB, and later First Republic Bank, was helped in part by the use of federal funding programs that let banks swap high quality but low interest rate assets on their books for cash. Those programs have seen reduced interest recently but are still in use, and investors may want to keep an eye on them going forward. For example, the Bank Term Funding Program, which allowed banks to get loans of up to a year in exchange for collateral, reported $114 billion in outstanding advances as of the end of November , which means the total amount of borrowed money outstanding has been mostly flat for several months. That funding facility is open until at least March 11, 2024, and many of the loans will likely extend out beyond that date. But if rates keep falling, there should be little need for additional borrowing. Banks lowered the rates they pay on certificates of deposit for the first time this cycle during the first two weeks of December, according to Morgan Stanley, a positive sign for customer cash levels. Now that rates appear to have already peaked for this cycle and have started to come back down, Wall Street can focus more on a potential upside for the regional banks if the economy achieves a "soft landing." That's when inflation declines and the economy continues to expand. "The pressure points on the sector have mostly stemmed from the risk of higher for longer interest rates. The possibility that the Fed could cut interest rates without a U.S. economic recession (= a potential 1995 scenario) reduces the risk of a deep credit cycle (= higher stock valuation multiples)," Bank of America analyst Ebrahim Poonawala said in a Dec. 14 report. How to play it Investors looking to bet on a broad rebound in the regional banking sector could use exchange-traded funds such as the KRE or the iShares U.S. Regional Banks ETF (IAT) . A key difference between the two is that the IAT has more exposure to the so-called "super regionals," such as U.S. Bancorp and PNC Financial , which performed relatively well in 2023. Another approach would be to pick and choose individual banks based on their credit exposure and the risk outlook. For example, the Smead Value mutual fund has added 1% positions in Western Alliance , Fifth Third and M & T Bank during the third quarter, in part because those banks have less exposure to office loans. "We do not think that there is good economics in trying to get people to go back to downtown office buildings," Bill Smead, chief investment officer at Smead Capital Management, told CNBC. Smead sidestepped that by finding banks that "were above the fray and then, secondly, had recent insider buying." Western Alliance, headquartered in Phoenix, Arizona, was also highlighted as a potential outperformer by Bank of America and RBC Capital Markets. Another bank that came up in multiple year-end lists was New York Community Bancorp , which acquired part of the failed Signature Bank in March. Poonawala and Raymond James analyst Steve Moss both listed NYCB as a buy candidate for 2024. New risks Of course, just because the risks that hurt regional banks in early 2023 appear to be fading does not mean new ones aren't around the corner. The fast-growing area of artificial intelligence could pose a risk to regional banks, which typically lag behind their bigger competitors in technology improvements, JPMorgan analyst Steven Alexopoulos said in a Dec. 12 note to clients. "Even with the technology advancing at a blistering pace, most of the regional banks that we spoke with are still working from the historical 'fast follower' playbook as it comes to adopting new technologies. While a 'fast follower' strategy has worked in the past with digital banking and prior technology waves, we do not see this to be a prudent strategy with AI," the note said. Alexopoulos cited Cullen/Frost and Live Oak as two regional banks that look to be ahead of their peers in preparing for AI. — CNBC's Michael Bloom contributed reporting.