Implications of a Faster US Banking Transition

Written by: Richard A. Brink, CFA

The incredible shrinking US banking sector isn’t a new story—in fact, it’s been under way for decades. To understand the changes and what they mean for investors, we took a deep dive into the transition in our most recent AB Disruptor Series podcast. Here’s a brief summary of the discussion.

The US banking sector has seen its ranks whittled away over the years by a series of crises and aftermaths. From a peak of about 30,000 banks in 1921, the number of banks had fallen to roughly 14,000 by 1934. Another round of crises in the late 1980s and 1990s, followed by the global financial crisis, shuttered more banks.

By 2019, roughly 4,500 US banks were left standing, the ranks thinned by the rising costs of regulation, technology and competition. Stiffer regulation required investments in compliance systems, while tech-empowered consumers demanded the same type of service from their banks. Intense competition came from larger banks and private lenders—nimble players not subject to bank regulations. 

COVID-19: Accelerant to an Already Burning Flame

The COVID-19 era exacerbated the banking squeeze. With interest rates artificially depressed in the years before and during the pandemic, banks extended low-interest-rate loans and invested the capital in long-duration Treasury bonds, seeking to tap a bit more yield from their investments. 

That model faced a reckoning when inflation surged and the Fed hiked rates sharply in response. Banks suffered in two ways: the value of loan books tumbled while prices on long-term Treasury holdings suffered. Mortgage loans, already low earning, stayed around longer, because homeowners had little incentive to refinance. Customers, meanwhile, clamored for higher deposit rates. 

What’s Next for Banks? Likely a Faster Transition

Struggling banks are left with two paths: The first—short of going under completely—is to be sold to a bigger bank or merge with another, though regulatory guardrails may make this challenging. The second path is to bolster balance sheets and financials by selling off portions of loan portfolios. 

Interest rates are widely expected to decline, which could provide relief to depressed loan valuations and investment portfolios as well as boost loan refinancing. But the pressure will likely continue, with attrition accelerating from the recent pace of 1,000 fewer banks every five years. 

We think the speed of consolidation will depend a lot on the regulatory regime. A more accommodative framework could enable smaller banks to pursue growth through mergers in healthy ways, allowing revenue growth to offset higher regulatory charges from surpassing asset-based regulatory thresholds. In our view, this would be preferable to a cycle of ever-larger banks gobbling up smaller ones. 

Small Banks: Survival of the Fittest  

What does all this mean for equity investors evaluating opportunities in a banking sector that seems to be in perpetual transition?

Smaller banks face the aforementioned regulatory asset thresholds and, in our assessment, have largely commoditized business models, so it seems to be a case of survival of the fittest. Think of banking models as having two pillars: The stickiness of the customer deposit base is one pillar—ideally, local depositor money that helps keep funding costs down. The other pillar is a relatively conservative loan portfolio. Better-positioned banks will likely have steady risk-management strategies and stick with business lines in their comfort zones.

From our perspective, investing comes down to winning by not losing. Look for management teams that execute well on the two pillars and avoid those that try to grow too fast or move beyond their spheres of expertise. An indiscriminate sell-off could present an opportunity to increase banking exposure more broadly, with the potential to identify healthier banks that were excessively punished.

Large Banks: “Gold Plated” Standards…or Not?  

Among large US banks, much attention is falling on the final stanza of Basel recommendations. Each country decides how to implement the global standards, and the US “gold plated” version is much stricter than other countries’. Banks have been investing for this new reality, and based on our analysis, markets seem to be pricing in a roughly 50% probability that the gold-plated standards will be watered down by the proposed July 2025 deadline.

If that happens, we think it could benefit valuations—for some banks more than others. Think of it as a “regulatory option” for investors. There’s concern from industry advocates and—in a unique twist—even acknowledgement by policymakers that stepping too hard on US banks could impose a competitive disadvantage versus Europe.

Beyond the Basel factor, the opportunity set seems idiosyncratic. From our perspective, it’s really about knowing individual banks’ business models and fundamentals, interpreting the storyline and identifying relative value. The stories can differ: one example would be banks working off regulatory punishment that may face headwinds now but have the potential to emerge on the other side healed.

Private Lenders: Competitors…and Partners

Private lenders are a main source of competition for US banks, but viewed from another lens, they could be considered partners, as they step into areas where banks can’t—or won’t—reach, given financial pressures or regulatory constraints.

As the banking transition accelerates, we think these opportunities will expand across many avenues. For example, private lenders can seek to buy existing loan portfolios from banks at a discount—an attractive investment in exchange for funneling needed capital to banks. Forward-flow agreements arrange for private lenders to buy banks’ future loans, enabling them to continue originating new loans.

In filling the lending gap left by bank retrenchment, private lenders have also developed the expertise and infrastructure to do their own lending. The playing field is much broader than that of mortgages, extending into areas that might be less capital efficient for more heavily regulated banks, such as commercial loans, auto loans and credit cards. 

High Yield: Reshaped Market, Opportunities Lower in Capital Structure  

The banking transition is also reshaping opportunities in the high-yield bond market—along with the market itself. For one thing, overall quality is rising. COVID-era defaults removed some weaker firms from the index, while private lenders are increasingly channeling funds to banks that might have previously issued bonds in the lower-quality rungs of the public high-yield market.

This process is altering the market’s technical conditions. For many years, annualized growth in net new issuance ran at about 8%–10%. Today, supply is shrinking, and the total dollar amount of the market is down by about 20% from its peak. This stronger technical backdrop, along with generally higher quality, is compressing high-yield credit spreads.

But we think opportunities remain. For example, with tighter regulation elevating large banks’ credit quality, investors can move down the credit spectrum to subordinated capital rungs in large banks, which we think presents equity-like return potential from strong and improving issuers. It’s harder to get comfortable with smaller regional banks. 

There are indirect impacts on high yield that investors must also consider, such as banks’ challenges potentially spilling over into adjacent industries. For example, pressure on commercial real estate from lower office occupancy is creating the need to work out a sizable existing supply. This could make new building more sporadic, which hurts the outlook for companies that install HVAC systems in buildings.

AB’s Disruptor Series is designed to provide distinctive perspectives on critical issues facing the capital markets today.

Related: Private Credit Forecast: Optimism Amid Rising Rates