Consumer and corporate borrowing has rebounded this year, and the economy looks to book its third consecutive quarter over 3% growth for the final three months of the year. That would have shares of financial institutions booming were it not for two factors working against the industry.

Shares of banks have underperformed this year on a narrow net interest margin, the difference between long-term and short-term rates, and continued regulatory costs from post-crisis legislation. The SPDR S&P Bank ETF (NYSE: KBE) has returned just 3.3% this year versus a 15% increase in the broader S&P 500 index.

Despite increases in the short-term benchmark rate by the Federal Reserve and more on the way, higher rates on the short end of the yield curve haven’t translated to higher long-term rates. Subdued inflation and fears over long-term economic growth have kept the rate on the 10-year Treasury well under 3% all year.

That means the net interest spread, the difference between the rate paid by banks on deposits and what they collect on longer-term loans, has held back profits.

#-ad_banner-#The other factor holding banks back is high regulatory costs for compliance and capital requirements, especially for banks listed as systemically important financial institutions (SIFI). Colloquially, these banks are called “too big to fail.”

But both of these factors could be about to change in 2018, with a wave of changes to leadership at regulatory institutions and the potential for higher rates and continued growth.

A Civil War At The CFPB And A Bank-Friendly Congress
Richard Cordray announced mid-November that he would be leaving as head of the Consumer Financial Protection Bureau (CFPB), the main regulatory body enforcing Dodd-Frank provisions in the banking space. Cordray was a major proponent of oversight and publicly clashed with President Trump and others.

After a contentious standoff over the CFPB’s leadership, it looks as if Mick Mulvaney, Director of the Office of Management and Budget, will take the helm until a new director is confirmed by the Senate.

A Mulvaney-led CFPB would almost certainly mean limited regulatory oversight and costs for banks. 

President Trump has gotten another ally in his promise to draw back on government regulations with the confirmation of Joseph Otting as the Comptroller of the Currency, another institution with oversight power through Dodd-Frank.

At the heart of this for banks is the Dodd-Frank legislation that set strict capital and compliance requirements after the 2008 crisis. Besides a change in oversight leadership, the legislation itself may soon change to take much of the burden off of some banks.

A bipartisan Senate panel agreed in November to modify Dodd-Frank, potentially exempting some banks from the Volcker Rule that prohibits certain types of speculative investments and raising the asset threshold for banks labeled as SIFI.

The current threshold of $50 billion in assets designates 35 banks as SIFI but could be raised to as high as $250 billion which would mean only 10 banks receive the designation. SIFI banks have strict capital and liquidity requirements that restrict how much of their funds are available for lending. They also have increased compliance costs through stress test reporting and risk management.

Deregulation And Higher Rates Could Boost These Banks
Beyond this potential for deregulation, general economic growth should boost long-term rates and support profitability. An unemployment rate at multi-decade lows means employers will need to raise wages to compete, potentially spurring inflation and helping to drive rates higher.

The banks with the most to gain in all of this would be those within that $50 billion to $250 billion asset range that could see relief with changes to Dodd-Frank legislation. These banks would see more capital open up to lending and their cost of compliance plunge.

Fifth Third Bank (Nasdaq: FITB) has $141 billion in assets as measured for the SIFI test and more than 1,300 branches throughout the Midwest and Southeast. The bank has historically been one of the most profitable in the group, with a 1.4% return on assets and double-digit return on equity. 

Fifth Third and other banks with the majority of business outside the Northeast and West Coast could see an unintended gain from tax reform being pushed through Congress. If deductibility of state taxes is withdrawn, primarily benefiting those in high-tax states in the Northeast and West Coast, we could see an increase in the economies and populations of lower-tax states.

Citizens Financial Group (NYSE: CFG) reports $152 billion in assets and a higher concentration of branches in the Northeast, but has a strong market share of 12% in its top ten metropolitan areas. Business is nearly evenly split between consumer lending (45%) and commercial loans (55%) and a technology investment program is driving a target for up to $60 million in cost savings by the end of 2018.

A new FinTech investment platform may help boost the bank’s services in wealth management, a historically weak segment for the company. Citizens has also been expanding its commercial lending portfolio into the Southeast which should help drive higher revenue. 

Regions Financial (NYSE: RF) has $125 billion in SIFI-measured assets and also focuses its operations in the Midwest and Southeast. A cost-saving initiative has helped the bank increase its earnings and savings goals for two quarters and management now believes it can complete the program, saving $400 million in expenses a year earlier in 2018.

Expense management and the potential to deploy more capital will go a long way to improving the bank’s 7.2% return on equity. Earnings are expected higher by 13% over the next four quarters and the shares trade for just 1.1 times book value.

Risks To Consider: Long-term interest rates have been stubbornly weak lately and could limit bank profits if expectations for higher rates do not materialize.

Action To Take: Position ahead of modifications in banking regulations and a potential increase in profitability and investor sentiment for banks between the $50 billion and $250 billion asset size.

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