Why Regional Banks Could Soon Cash In

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If the Fed has to start tightening, and we think they will, then our balance sheet is asset sensitive, which means ultimately we'll be repricing our loans faster than our deposits and our net interest income will go up.

Welcome to the Barron Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Bruce Van Son. He's the CEO of Citizens Financial Group, which is the 13th largest US retail bank. You just heard Bruce use terms like Fed tightening and asset-sensitive balance sheet and Net interest income. Don't worry, I speak fluent banker. Bruce means that if interest rates rise, banks in general and his bank in particular are likely to earn higher profits. Coming up, we'll talk about the outlook for bank stocks and hear more from Bruce and a top Wall Street analyst. Listening in is our audio producer Jackson. Hi Jackson.

Hi, Jack.

I have a game for you and it's called Bank or Not a Bank. Are you ready to play?

I'm ready.

I'm going to name 5 banks. Only 4 will be real and you guess the imposter. The banks are Aspiration. This one fights climate change by rounding up transaction amounts to the nearest whole dollar. Next one. Cheese. It aims its services at Asian Americans. Salad. That gives 10% cash back at vegan restaurants. There's Dough. It's spelled with two U's, and they use artificial intelligence-powered banking. And finally, Daylight offers banking for the LGBTQ community. Which one is the imposter?

I'm gonna have to say Cheese is the phony.

Cheese is quite real. It's a year old and it offers what it calls reliable bilingual support and cash back for spending at Asian-owned businesses. The imposter is Salad. But there is a bank that rewards customers for spending at vegan businesses. It's called Purpose, not Salad. Jackson, I don't want you to get down on yourself just because you guessed wrong. You're going to get another chance later in the show, and we're all rooting for you.

It's all right. Even the, even the greats have a batting average of.300.

In one sense, the US seems flooded with new banks. There are countless neobanks or challenger banks and other fintech startups that offer app-based access to banking services, and which say they alleviate pain points of traditional banking, or which cater to specific groups of customers. How do you cater, for example, to LGBTQ customers? Well, Daylight says it offers money back for spending at what it calls LGBTQ-allied businesses, and it says it will recognize customers by names they choose not just names that are on their identification cards. Daylight is new, so time will tell whether that's enough to win over a large customer base. And profitability is another matter altogether. One of the largest neobanks, Brazil's Nubank, recently went public as Nu Holdings, ticker NU. The bank is backed by Warren Buffett's Berkshire Hathaway, and it hit a market value of more than $50 billion on its first day of trading. Even though it's expected to report financial losses this year and next. Investors might be excited because consumers made a pronounced shift to online banking during the pandemic when bank branches were closed. Plus, Nubank serves many parts of Latin America where bank branches are scarce to begin with. Warren Buffett's involvement surely helps, but whatever the reason, it's clear that capital is abundant for tech startups offering financial services. Regardless of their profitability. There's a challenger bank in the UK called Revolut that's 6 years old and losing money. A summer funding round valued it at more than $30 billion. It recently announced it would go into no-fee stock trading. The UK and US markets look particularly competitive for neobanks. A German neobank called N26 recently said it's withdrawing from the US after 2.5 years. It had already pulled out of the UK. So it's by no means assured that neobanks will displace or disrupt traditional banks. This past summer on this podcast, we spoke with Bank of America CEO Brian Moynihan, and he didn't sound particularly disrupted.

We had, you know, very strong growth in new customer checking accounts, very strong growth in customer acquisition in the wealth management business. We are a growth company in a very big shell.

Let me also make clear that although there's a flood of new companies offering banking services, there aren't many new chartered banks— that is, companies with state or federal charters that let them do things like insure deposit accounts and offer a full menu of lending. Neo banks typically use other chartered banks to be able to do those things. For example, Dou, the one with two U's, that uses Choice Financial Group. Sometimes neobanks become chartered banks, like one called Varo did last year, but so far that's fairly rare. One study by the Federal Reserve Board noted that between 1990 and 2008, there were more than 100 new bank charters a year on average. But over the following 4 years, marking the period just after the global financial crisis, The average was just 7 a year, and the numbers have continued to dwindle. One reason could be increased regulations, which can be particularly expensive for small banks. But the biggest reason could be a combination of sluggish economic growth and near-zero interest rates. See, banks make money in two broad ways. One is by charging more for loans than they pay for deposits. Resulting in something called net interest income. Jackson, you think listeners are losing net interest at this point?

Maybe a few basis points.

Well, I'm going to come to basis points in a minute. Now, rates on loans and deposits tend to rise and fall in tandem with each other, but there's a floor for deposit rates of 0% because banks generally aren't going to begin charging customers interest on their savings deposits. So when deposit rates hit that floor and loan rates kept falling, one result was squished lending spreads. Right now there's also a glut of savings relative to loan demand. I mentioned that there are two ways banks make money. The second one is charging fees. Some of those, like overdraft fees on checking accounts, are in steep decline because regulators don't like them and many neobanks don't charge them. Forcing some traditional banks to drop them. Fees for things like investment banking and advising on mergers and acquisitions remain robust. In fact, one of the hottest sectors for dealmaking is the banking sector itself. Through the end of November, there were more than 200 deals, which is twice as many as a year ago. So the number of banks is actually shrinking despite appearances. Let's come back to that. To learn more about banking conditions, let's check in with a bank. And since we heard not too long ago from a giant money center bank, let's hear from a regional bank. Hiya, Bruce. Jack Howe from Barron's.

Hey, Jack, how are you?

That's Bruce Van Son, and he's the CEO of Citizens Financial Group. It was bought decades ago by the Royal Bank of Scotland as a way to get into the U.S. market. But the Royal Bank of Scotland was hit hard by the global financial crisis and it needed money, and it wasn't able to invest as much as it wanted in the U.S. So it took Citizens public in 2014 and got out altogether the following year. Citizens has made a string of recent acquisitions that give it a strong branch presence from New England down through New York City and into the Mid-Atlantic region. And more ability to earn fees from mergers and acquisitions, especially in technology, healthcare, and banking. It also has its own online-only bank called Citizens Access. We've talked in recent weeks about how, with the U.S. inflation rate spiking, the Fed has signaled an increased willingness to raise interest rates in the year ahead. And at the beginning of this episode, you heard Bruce say that. That would be good for profits. That's a widely held belief and something that has drawn investor attention to banks now. But Bruce also says he can prosper even without higher rates from a combination of fees and making good use of his acquisitions.

Even in this low rate environment, we're still putting up good numbers. We've had good diversification in 2020 when rates went down and the pandemic killed it in the mortgage business. We've made a lot of mortgage fees as people refinanced their mortgages. And then we passed the baton this year to capital markets with all the market activity, M&A, and the like.

I asked Bruce about his growth ambitions for the coming years.

Our ambition is to be a top-performing, widely respected regional bank, super-regional bank in the country. Since we have a digital banking capability, we were focused initially on just deposit raising, but now we're linking some of our national lending products onto the same platform. So we can start to go around the country with our digital bank and then potentially have some thin branches and hopefully gain some market share and become more well-known across the rest of the country out of the core retail footprint.

When Bruce says thin branches, two markets come to mind. He has 8 branches in the Washington, D.C. area and 6 in the Miami area. Acquisitions are one way to expand, and spending money to open new branches is another. But Bruce is saying that having an online-only bank, particularly one with a growing number of lending capabilities, gives him an opportunity to expand in markets like those digitally for now and add branches only if they're needed. It's a lower risk and less expensive way to grow. I asked Bruce a question about cryptocurrency. I come to you and I say, Bruce, I'm very happy with my relationship with Citizens, but gosh darn it, I want to use my parody dog cryptocurrency to buy some digital pet rocks out there on the internet. And if you can't do it for me, then I'm going to go to this other online, whatever. How do you handle that decision of whether to dip a toe in or what to make available to your customers?

Yeah. So right now, Jack, it's interesting. I think the Treasury put out a paper and they would like the banks to be participating and keep some of this activity in the banking system. But the regulators just put out a paper that said we need to study these risks and you can't really get to first base until we tell you to. So we're kind of caught between two currents there. And certainly our customers, particularly younger customers, are all in. They want to explore Bitcoin and other cryptos and hold that as an asset class in their portfolio.

Bruce says customers can house pooled crypto investments like ETFs for now, and that he'll consider adding more services down the road. I asked Bruce which growth opportunities he's most excited about, and he mentioned gaining share in capital markets, meaning investment services for commercial clients, and in wealth management, meaning earning fees for advising rich people on staying rich and getting even richer. I asked about winning over young customers. How do you get in front of that younger generation, or how do you convince them to stick around with you if their parents were with you? I mean, aren't they out there looking at TikTok and getting their financial advice out there? Like, you know, how do you—

you know, we've been very successful in a targeted offering around young professional mass affluent segment of the customer base. We do that really well in our core footprint. And that's one of the things we want to take around the country with the National Digital Bank. And the reason we're successful there, I'd say we have a hook. We have a lead product in student loan refinancing. So kids graduate from college and they have high-cost debt and we can help refinance that and put money back in their pockets, save $150 a month, which is real money. And at the same time, build that relationship, get them to bring their checking over, start to give them wealth advice. Start to help them plan for their first home.

Bruce makes the point that Citizens and the banking industry in general are well capitalized and not taking undue risk. He thinks loan demand will be solid as the pandemic passes and the economy reopens, and he's not shy about making the case for his stock.

Our goal is to continue to drive up our return on tangible equity, and if we do that on a consistent basis and get it a little higher I think the stock can really unlock and continue to do nicely.

Thank you, Bruce. To learn more about the outlook for bank stocks, I checked in with a top Wall Street analyst, and that's next after this short break.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.

Welcome back, Jackson. You ready for Bank or Not a Bank, the redemption round?

I was born ready.

This time I'm gonna name 4 banks and 3 of them are real. Here we go. Greenlight, that offers debit cards for kids that are managed by parents. Then there's a bank just called Dave. That's backed by Mark Cuban. They have free overdraft and some budgeting features. Karat, spelled with a K, that's for content creators and influencers. And finally, Flavortown Bank. That's backed by celebrity chef Guy Fieri, and customers can earn Holy Moly Stromboli points, which can be redeemed for actual strombolis.

There's no way that last one's real.

It's not real, but Guy, if you're listening, give me a call. I got a pitch for you. Think debt consolidation and gravy fries.

I've actually never been inside a bank, so if they had gravy fries, that might change the equation.

Get your first customer, Guy. Now then, time to hear from a top Wall Street bank analyst.

So I cover everything. I head North American banks, so I cover everything from JP Morgan, Morgan Stanley, to regional banks like Key, M&T, to some of the more mid-cap names like Silicon Valley, Signature Bank. And I also had the coverage of the Canadian banks.

That's Ibrahim Poonawalla. He's the head of North American banks research at Bank of America Securities. I asked him if now's a good time to invest in banks, and he said yes, even though the latest rise in COVID cases could create economic volatility in the short term. There are 3 broad things that Ibrahim likes about banks now. The first is that, as I said earlier, banks are sitting on a massive amount of excess cash. Ibrahim says the loan-to-deposit ratio for the average bank he covers is 66% now versus 85% at the end of 2015. As banks put more of that money to work by lending, or even just buying securities, they'll make more money. And second, rates now look more likely to rise. Here's Ibrahim.

We've gone from Fed hiking in '23 to maybe Fed hiking as early as March. And US banks, as you probably well know, are very levered to the short end of the curve. So the Fed hikes, they don't need to raise deposit costs as quickly, even more so even the last cycle, given all the excess liquidity they're sitting on. Like if you go back to the 2015-16 rate hike cycle, for the first 100 basis points, deposit costs went up by 10 basis points, right? So the ability to lag is even more today than it was back in '15.

Did you catch that? 100 basis points is another way of saying a full percentage point. So Ibrahim is saying that the last time the Fed raised rates a full point, deposit costs went up by by only a tenth of a point. That's because banks, which had seen their loan spreads compress, were letting them re-expand. And Ibrahim says their ability to do that this time around is even greater. There's a third thing that Ibrahim likes about banks now.

Lastly, I think banks are a big play on inventory rebuild, right? So we've all talked about supply chain issues and banks are big financers of inventories, be it Dealer floor plan is the best example, but if you've gone to buy a car in recent months, there is no new car.

Abraham says some banks have had their dealer floor plan balances, or the amount they lend for car inventories, cut by more than 80%. As dealers restock, those banks will rebuild their loan balances. And it's not just for cars, it's across the economy. Ibrahim says the banks he talks to seem to have shifted from a defensive posture in the years following the global financial crisis to more of a growth footing, doing acquisitions and investing in technology. He says it's a good time to favor regional banks because they have above-average exposure to rising interest rates. Ibrahim recently upgraded his rating on KeyCorp from underperform straight to buy. He likes that the company has been investing in technology, including through fintech partnerships and acquisitions. And he points out that although Key is big in the Midwest and Northeast, its best growth is coming from altogether different markets.

And West Coast is booming. They're adding clients there at 2x the rate. So the exposure to some of these faster growth markets from like California going up to Seattle and cities over there one creates a lot of differentiated opportunity to acquire new clients and growth. You add to that the fact that management's been quite smart about targeting certain industry verticals, right? So affordable housing, renewables, healthcare— these are areas of the economy which are in secular growth. So they've aligned themselves, be it in their capital markets business, be it in their lending business, quite intelligently to these.

Ibrahim also has a buy rating on Citizens. He says one thing that could weigh on the stock in the short term is that investors sometimes get nervous when they see a lot of acquisitions. But he also says that the acquisitions will create what he calls a much better company 2 or 3 years from now. I asked Ibrahim, aren't there too many bank branches in the U.S.? And he said, not only are there too many branches, There are too many banks.

So there are too many banks in the US. We have close to 5,000 banks, probably 4,500 or so are less than $1 billion in assets. Right. So really community banks. So one, I think you have a sector that's consolidated for the last 30-plus years. That number will continue to shrink, maybe half over the next 10 years. On top of that, I think you're going to see branches— what you saw even during the pandemic, an acceleration in digital adoption. Yes. So I think management teams will strategically refine their branch footprints where it's like like, you know what, we don't need to be on every corner in a certain area. We can have one branch which addresses a much larger market, maybe 2x or 3x of what we thought previously. And part of it is the reason why the customers going into the branch today is very different than 5 years ago. It's to seek advice. It's more higher value-add services than just depositing a check or withdrawing cash from the teller window.

Thank you, Bruce and Ibrahim, and thanks to all of you for listening. Jackson Cantrell is our producer. Jackson, quick bonus round. You ready? Yep. Bank or not a bank? Swing Split. It offers checking accounts for divorced trapeze artists.

That's definitely a bank.

It's a pre-seed blueprint of a bank that I just made up, and it's already worth $30 billion. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, write us a review. If you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @JackHowe, H-O-U-G-H. See you next week.

Yeah, divorced trapeze artist, that's a tricky tax situation. I think you're on to something.

Definitely a deduction for hand chalk.

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