Market Update

Will Relaxed Regulations Boost Bank Stocks?

Bryan Borzykowski

Last month, Congress rolled back a bevy of Dodd-Frank-related reforms, with the hopes of making it easier for small and midsize banks to operate and earn more. It was the most significant easing of financial sector regulations since the recession, when rules were put in place to help prevent another downturn. But these changes aren't putting the country at risk, as some politicians have suggested, says Eric Compton, a bank analyst with Morningstar. 

The deregulation doesn't impact the largest banks (they must still adhere to the same post-recession rules), nor does it allow financial institutions to engage in the risky lending practices that brought down the economy a decade ago.

"The rhetoric before this got passed sounded pretty aggressive, but it's tame in a lot of areas," says Compton. "I would say to people who think this is a return to the crises of 2007 that it's not. A lot of changes are around the margins."

Even more peripheral changes, though, can have an impact on bank earnings and returns. With financial sectors stocks having their best 12 months since 2008--the S&P 500 Financials subindex is up 17% compared to 12% for the S&P 500 as of this writing, though the sector is down 1.8% on the year--investors may be wondering if these reforms will give banks yet another boost. 

Two Big Changes
Out of all the reforms made, only two are significant enough to potentially move the needle on bank stock prices, says Compton. One of these bigger changes is to the supplementary leverage ratio, which is a calculation that banks use to show that their institution isn’t over levered.

Until just recently, banks, and in particular custodian banks--the companies that hold securities for safekeeping--couldn't count any money held with central banks in that calculation. Now they can, which means they don't need to hold as much money as they used to in order to meet those leverage ratios. 

This change should lead to higher profitability, says Compton. Companies will now have more money to buy, say, a basic basket of securities, which could then boost earnings, or return some of those funds through dividends or share buy backs.

"With this change, banks can now lever up a little more and maybe buy more securities," he says. "That will give them more profits."

The other major change is to what's defined as a "systemically important financial institution." Banks that receive this designation are considered "too big to fail" and, as a result, are subject to a wide variety of regulatory rules, including stress tests and higher capital requirements. Complying with these additional measures is expensive and time consuming.

Previously, any bank holding $50 billion in assets was deemed a systemically important financial institution. That threshold has now been increased to $250 billion, which is "very positive for the regional banks," says Lisa Welch,  lead manager of  JHancock Regional Bank (FRBAX), which earns a Bronze rating from Morningstar. "Smaller banks won't be subject to the Fed’s stress tests anymore."

This, too, should give profits a boost. Banks will no longer have to spend as much money on compliance costs--they have to pull together about 40,000 pages of materials every year, says Welch, plus get ready for stress tests--and that should lead to higher capital returns, she says. Banks will also have more money on hand to return to shareholders via dividends and buybacks. 

Increasing the systemically important financial institution threshold should lead to more competition among banks and an increase in M&A activity, too. Many institutions haven't wanted to grow beyond $50 billion in assets to avoid the increase in regulation, but now they might think otherwise. A couple of $50 billion banks could merge, or maybe a $100 billion one buys a smaller institutions, but still stays under the $250 billion line.

"Banks did a number of things to make sure they stayed below that $50 billion level," says Welsh. "Now we could see more M&A activity among banks that are different sizes."

Wait Before Buying?
While these changes should give regional banks more money to play with, will they give their stocks a jolt? Kevin Holt, Invesco's chief investment officer of U.S. value equities, says that reduced regulations do make bank stocks more attractive, but he also wants to see what comes next.

"There's not a really a ton to discuss yet," he says. "This may spur consolidation of small and midtier banks, but other than that, it's more behind-the-scenes things where previous regulations are being interpreted slightly differently."

He's waiting to see what happens with the results from the next Comprehensive Capital Analysis and Review--the official name of the bank stress tests--which are due in June. Some experts think that if all the banks pass, which they likely will, then the government could lift some of the reporting requirement rules associated with these tests.

"When CCAR comes out in the next few weeks there will be more of an indication where things are heading," he says. 

Compton adds that regional banks are fairly to slightly overvalued, even though the financial sector as a whole is undervalued. According to Morningstar, the financial services sector is about 7% undervalued as of this writing, though regional banks specifically are about 5% overvalued. Compton thinks deregulation has been priced in: Bank stocks have done well since Donald Trump was elected because of his anti-regulatory stance. Prices would need to fall between 10% and 15% before Compton would recommend buying in. No regional banks are trading in 4- or 5-star range at the moment, he adds.

Welsh has a different view. She thinks the current rule changes and potential future changes--there's now talk of repealing the Volcker Rule, which partially bans proprietary trading by the banks--aren't yet priced in. On a price/book basis, the banks also look undervalued, she says. Historically, banks have a P/B ratio of about 1.8 times, but it's around 1.5 times today. The sector also has high returns on equity, and it will benefit from higher interest rates, a more favorable tax regime and a strong credit environment.

"We see very good opportunities for investing in this sector," she says. "We're positioning our portfolio to benefit from rates moving up and net interest margins expanding, which will lead to higher earnings growth."

Investors who either want to get in now with the hopes that stocks will rise, or who want to jump in when the sector dips, have three Morningstar medalist financial funds to choose from:  Davis Financial (DVFYX), Franklin Mutual Financial Services (TFSIX), and the John Hancock Regional Bank fund, all of which earn Bronze ratings. But be mindful that many large-value funds own a hearty dose of bank stocks. Investors may already have a stake in the industry.

While investors will have to decide for themselves whether the banks are worth buying now, relaxed regulations are certainly a positive for these companies and their shareholders.

"The narrative for about six years after the crisis was that banks are bad, stay away from them," says Compton. "But over the last year, that's shifted to everything is going right. I'd wait to buy, but it does seem like many are more optimistic on the sector now."

Bryan Borzykowski is a freelance columnist for Morningstar.com. A Toronto-based business and investments writer, Bryan has contributed to The New York Times, CNBC, BBC Capital, CNNMoney and other publications. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

Bryan Borzykowski does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.