Q&A: The State of Banking & the Public Market with Wolfe Research’s Steven Chubak
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On the heels of recent upheaval in the banking industry, Prosek’s Stefan Norbom, a Vice President on our Investor Relations team, hosted an internal “Orange U” training session to help us make sense of what’s occurred in the public market and prepare for what’s ahead.
Stefan held a fireside chat with Steven Chubak, a Research Analyst for banks and brokers with Wolfe Research, LLC, a leading global equity research firm. Among other achievements, Steven was recognized as a top ranked Institutional Investor analyst in 2022 and recognized by Institutional Investor as a “Rising Star” for his work in the Bank, Broker and Asset Manager categories. Prior to Wolfe, Steven worked in equity research at Nomura, Autonomous, Bank of America and JMP Securities covering banks and brokers for over a decade.
Together, Stefan and Steven reflected on the current economic environment--and how the Federal Reserve is impacting it, lessons learned so far, and their outlook for the rest of 2023. Here’s what they had to say…
1. During recent weeks, we’ve seen significant stress on the banking system with the failure of Silicon Valley Bank, First Republic dodging a potential collapse, and UBS announcing its acquisition of Credit Suisse. Can you start us off with your thoughts and overall reflections on recent developments and the current environment?
You never want to see any bank suffer a run and then ultimately go into FDIC receivership like what we saw with Silicon Valley. I think it's pretty clear that there has been a little bit of a paradigm shift where, now, money is so fungible and can easily be moved from one institution to another.
What's different with the Silicon Valley Bank run, relative to what we experienced in 2008 with Washington Mutual (WaMu), is the speed at which it took place. That compels the regulators to focus more on safety and soundness and to not simply limit their focus to the eight systemically important banks. For the time being, they're looking at the $100 billion-plus cohort and acknowledging that the risk doesn't exclusively lie with the global interconnected institutions. Worth noting, they actually rolled back some of the banking regulations during the Trump Administration in 2018 and 2019, where they imposed really tough standards on those eight, and then were much more lax with the other regional banks. Hindsight's 2020…as that was clearly a mistake.
In terms of where we stand now: the good news is that the regulatory response has been so strong that I don't think people really view this as an existential risk or crisis for any of the banks. That being said, the regional banks are still viewed as being on shaky ground at the moment, and there's been significant inflows over the last couple of weeks out of the regional banks and into the big money centers. We only have data on that through March 15, but the data we do have suggests that while that case is slowing, it has continued. So the outcome is that the regulators are going to subject these regionals to tougher and likely comparable standards that are at parity with the most systemically important institutions.
As I think about what that means for the environment, it's better safety and soundness for the system. But that also means lower returns on the go forward. Your earnings outlook has maybe changed slightly because you have to shore up your funding. That's expensive. But at the same time, you're also going to have tougher capital requirements. So even if the earnings were the same, if you increase capital requirements by 10% or 20%, the returns for those same banks are also going to decline a commensurate amount. So the 12% generator is now only going to be earning 10% on that new higher capital standard.
That’s what a lot of investors are focused on. They’re asking, “What's the new normal for returns when the dust settles and once the regulators have sorted out how the regime is going to change?” Certainly the status quo cannot be maintained. That's pretty clear.
2. As a sell side analyst covering more than 20 companies across brokers, asset managers, and exchanges, can you tell us about some of the conversations you’ve had (at a high level) with management teams? What are they focusing on?
First and foremost, they're focused on funding stress, and that manifests across a whole host of companies that we cover and track. Even the M&A independents, they're looking at what happens to rate levels, what happens to credit spreads, etc. and they’re wondering if there’s going to be financing availability where companies are going to pursue mergers.
I cover the retail brokers in addition to the bank—e.g., Schwab. It's not analogous to SVB, but there are parallels. They have a deeply underwater mortgage book. They're also $100 billion-plus in size, so they're going to be subject to a tougher regulatory standard. But I’d say, across my entire coverage, banks and brokers alike, and even the sponsors like the alternative asset managers, they're all looking at funding stress, the direction of rates, how they can shore up their balance sheets, etc.; and they’re wondering if this will lead to trying to raise additional deposit funding in the marketplace, if there will be a rise in more wholesale borrowings, etc.
It also raises questions around lending. I think that’s probably the biggest question mark at the moment, especially when I talk to generalists who aren't quite as in the weeds on the financial companies, specifically, as they're worried that the lending spigot is going to shut off. We didn't see that in the latest data from the Fed, but that's something that we're hearing more and more—that lending is going to be constrained. Less credit availability is just bad for the economy, broadly, so what I'm hearing from management teams is they're still extending credit, but they're definitely tightening their underwriting standards. That is going to have implications for economic growth.
Buybacks are another big area of debate at the moment. It almost feels like banks, and financial companies more broadly, but banks in particular, might be inclined to pursue more M&A and more consolidation opportunities simply because, if you're a well-capitalized institution, even in the new regime, I think buybacks are going to be heavily scrutinized. You want to avoid that scrutiny, so it's not clear that the banks will shut off buybacks, but I think the hope or expectation was that we would see a wave of buyback activity this year to goose earnings, and it's not clear that the banks are going to be willing or inclined to do that.
I think what they're focused on right now is their stakeholders—not just the shareholders, but also how people are going to perceive their actions, and they’re focusing on trying to avoid a lot of publicity – and especially negative publicity – on that front. There's also just a lot of questions around funding stress, credit, long growth, etc. Ultimately, those are going to have significant implications, not just for bank returns, but also for the broader economy as a whole.
3. There’s a lot of fear in the market right now. What are the topics and primary concerns you’re hearing from institutional investors (and on the buy side)?
As it relates to financials, I think the concern is that it’s still too murky when it comes to what the regulatory landscape is ultimately going to look like, in addition to a lot of the macro concerns. If the banks shut off the lending spigot and credit availability just isn't as strong as it had been, some of these private credit players are not going to fill that void. Limited credit availability is definitely a concern and something that people are watching out for.
From the investors that we speak with, their big concern is that we can’t handicap the direction of travel on rates; that has huge implications for bank earnings. Also, the capital markets inflection, people were hoping for that in the back half. Based on my conversations with the management teams, it does feel, at least on M&A, that the timing's pushed out. Although, on the financial side, it could be a little bit more active for those that do need to restructure their balance sheets in particular.
Among the broader investment community, including the generalists that we speak with, their biggest concern is that the S&P earnings number is simply wrong. That number is going to have to get cut pretty dramatically, and when you adjust for that, the market is incredibly expensive. I don't know about you guys, but at least for myself, when I get certain bonus payments and the like and I have to decide where the money is going to be deployed, I deploy quite a bit more in fixed income securities. What we're hearing is that is a better return, and it seems like a safer return for the time being versus the equity market, where the earnings risk is far greater than what's reflected; and when you adjust for that, the S&P, at 16 times a headline number that's too high, that looks reasonably priced. But when you adjust for the true earnings number which could be below 200, you're talking about an 18-to-19 times-type multiple.
So that's the concern that we're hearing from folks, that the sell side has been slow to update numbers. And personally, I feel like the risk in S&P earnings is going to be far greater than what people are contemplating.
4. Earlier this year, you published a market outlook report highlighting concerns heading into the year and noted your increasingly cautious stance on the banks. Can you touch on your 2023 outlook and how it’s changed in light of recent events?
Our thinking has certainly changed quite a bit, in a large part because the valuations have come in a fair amount as well. The bank stocks have been hit pretty hard here, as have the brokers, especially relative to other sectors. We just talked about the S&P being up 3.5% on a year to day basis, and the KRE and the BKX are down 25% and 20%, respectively. So, you could certainly say that some of our concerns have come to fruition or are starting to get reflected in these stocks.
What's fundamentally changed is, for one, the expectation was that the Fed was going to be higher for longer, and that there was not any chance that they were going to start easing or cutting any time soon. People were really underwriting more of a mild recession, us included, in the back half of 2023, with either soft landing or no landing scenarios. Now, people are clearly ascribing a higher probability to that hard landing scenario in light of recent developments.
The expectation has also become, because the Fed’s hand is going to be forced, they’re going to have to cut more aggressively. That is not our firm view. We still believe it's going to be higher for longer, so we tend to favor names that are very rate sensitive but don't have a lot of credit or macro risk. The earnings outlook and expectations have fundamentally changed, and the inflection in investment banking could take longer.
The equity market backdrop is certainly choppier. It does feel like there's some greater risk to the downside. The deposit outflows that we've seen, particularly across the regional banks, is going away heavily on net interest income and margins for a lot of those names. Plus, the credit outlook is certainly worse. I think people generally felt pretty good about credit heading into the start of the year. We were worried in the back half that we’d start to see some uptick in charge offs. But as we go through that scenario analysis, we are certainly starting to contemplate worse outcomes than what we were considering as of 12/31 given everything that's transpired.
5. The majority of Prosek team members on the line focus on corporate communications and media relations. Given the volatile market, with expectations for conditions to worsen during the course of the year, what strategic counsel would you provide executive management teams? Are there any good or bad examples?
No one is immune to the issue of having deployed a lot of capital, or, I should say, “liquidity” when rates were much lower, right? So a lot of banks have deeply underwater securities portfolios; some have just managed it better than others.
You had to respect the unknown here. Though the magnitude of rate increases was unprecedented, the pace at which those rate increases were done was also unprecedented. A lot of banks were anchoring their guidance to what we saw in the last interest rate cycle of in 2015, 2019, etc., which was vastly different than what we're seeing and experiencing right now. That was more benign and favorable in terms of deposit beta increasing in an orderly rate, deposit outflows not being as acute.
This time around, the dark side of higher rates is much clearer. The increases happened too quickly. The deposit outflows have been much more acute. What we saw with SVB is that it can manifest very quickly. Because of that, I would say don't draw a line in the sand. These companies have to respect the unknown.
The biggest mistake that we've seen is from those firms that have said, “I can handicap yield-seeking behavior across my complex.” They’ve tried to defend their balance sheet strategies, their securities reinvestment strategies, and they’ve ultimately ended up with egg on their face. So it feels to me like what’s important is to respect the unknown. Don't give guidance 6, 12 or 18 months out if you're not comfortable with handicapping some of those risks.
My three key recommendations based on what we’ve seen is 1) don’t overpromise, 2) guide conservatively, and 3) don't try to draw a line in the sand on issues that are unprecedented relative to prior cycles. 
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