January 7, 2025

Bullish on U.S. Bank Stocks: Look Forward to 2025

Samuel Horn

ASSISTANT PORTFOLIO MANAGER

January 7, 2025

Bullish on U.S. Bank Stocks: Look Forward to 2025

Samuel Horn

ASSISTANT PORTFOLIO MANAGER

January 7, 2025

Bullish on U.S. Bank Stocks: Look Forward to 2025

Samuel Horn

ASSISTANT PORTFOLIO MANAGER

banks optimistic about regulatory trends, rate cuts and the U.S. economy

The U.S. banking industry had a standout 2024, as regional banks were up more than 32% year-to-date (per the SPDR S&P Regional Bank ETF (KRE) as of 12/24/24) and large banks stocks jumped by 34% YTD (per the S&P 500 Banks Industry Group Index as of 12/24/24). Where does the industry go from here?

Executives from some of the country’s biggest banks sound optimistic about 2025, primed for success against the backdrop of a new administration, fewer rules/restrictions, more favorable economic environs and more interest rate cuts. Its smaller regional brethren were equally enthusiastic, with many issuing upbeat guidance for 2025 and praising healthier valuations to enable equity issuances for growth or balance sheet restructurings for improved profitability. It is a far cry from the industry doldrums of 2023.

Polaris Capital assistant portfolio manager Sam Horn offers perspective on the current state of the U.S. banking system and 2025 expectations, within the context of Federal Reserve actions and recent U.S. presidential election results.

Q: TELL US ABOUT THE U.S. BANKING MARKET OF THE PAST FEW YEARS. HOW HAS THE INDUSTRY EVOLVED?

A: In March 2023, the collapse of Silicon Valley Bank and closure of Signature Bank caused a crisis of confidence in the U.S. banking industry. Spooked depositors moved money from regional banks to larger lenders considered “too big to fail”, while Federal regulators worried about a rush to withdraw at other banks. The Fed stepped in to retroactively insure deposits at SVB, hoping to smooth over contagion concerns. The strategy worked, as other bank runs never materialized.

Following the 2023 “March Madness”, banks encountered a 2024 interest rate “whipsaw”. This volatility, stemming from pandemic-era policies and subsequent efforts to control inflation, required banks to be nimble in their asset-liability management strategies. And by and large, the U.S. banking system proved up to the task.

U.S. banks are restructuring their securities portfolios to address liquidity needs, while capitalizing on investment opportunities in the Fed easing cycle. Basically, banks deployed more cash into higher-yielding assets as they sold off lower-yielding securities and as longer-dated, hold-to-maturity securities rolled off the books.

Assets: Lower interest rates have also boosted fee income by stimulating increased borrowing activity (mortgages/loans), as well as driving customers towards fee-based services like wealth management and investment advisory due to the need to seek higher returns in a low-interest environment. In essence, banks have started to prioritize non-interest income to offset pressure on net interest income.

Liabilities: We’re not seeing substantial deposit flows, as customers seem content with current rates. This stability likely stems from the anticipation of potential Federal Reserve rate cuts in 2025, which could lead to lower interest rates on deposit accounts.

Credit Quality: We haven’t observed a significant uptick in large charge-offs, although commercial real estate exposure, particularly office spaces, causes some consternation. Arguably, banks today show minimal exposure to these risks compared to what we saw in 1990. And among the banks with larger real estate loans, many are being re-worked between lenders and borrowers.

Expenses: Expense growth has been well controlled. Banks have invested in front-end and back-end system software to improve customer engagement and support for new product and account openings.

Capital & Capital Allocation: Many banks have largely rebuilt their capital buffers to comfortable levels as buybacks have paused post “March Madness”. This positions them well to 1) respond to regulatory requirements in anticipation of Basel III and/or 2) return capital to shareholders through dividends or share buybacks, a positive sign for investors.

Q: WHAT IS YOUR PREDICTION FOR INTEREST RATES IN 2025?

A: Our outlook for interest rates in 2025 is nuanced. As evidenced above, U.S. banks have been extremely adaptable and resilient, reworking their balance sheets and management strategies in a lower interest rate environment. But that could turn on a dime…

On December 18^th, the Federal Reserve made its third consecutive cut of 2024, lowering rates by a full percentage point since September. But more reductions hinge on combatting stubbornly high inflation, with Fed Chairman Jerome Powell suggesting caution with the incoming Trump administration. While price pressures are expected to ease, the Fed Board is beginning to ponder the incoming administration’s economic policies (promises of higher tariffs, onshoring, tax cuts and immigration policies) that may prove to be somewhat inflationary.

This draws into question the pace and magnitude of 2025 cuts, which may be more modest than previously anticipated. This could spell challenging news for the banks’ mortgage business, which typically benefits from lower rates. At the same time, higher-for-longer rates play into the “maturity transformation” business model, which is the bread and butter of the banking industry. With a steeper yield curve, banks are able to borrow money at low short-term interest rates and lend it out at higher long-term interest rates, resulting in a larger profit margin due to the significant difference between the rates.

Q: WHAT ARE THE MOST PRESSING CHALLENGES FACING THE U.S. BANK SECTOR?

A: Overregulation: The regulatory burden has been a significant factor driving industry consolidation, particularly impacting smaller institutions. The regulatory requirements for community banks are especially onerous, as they often need to implement the same systems and processes as mid-sized banks, despite having fewer resources. This disproportionate burden can hinder their ability to compete effectively and serve their local communities.

Inflation Trends: With some speculation that Trump policies might prove inflationary, the Fed may keep rates higher for longer. Add to the mix the strength of job market, which puts upward pressure on wages; companies respond by increasing prices on goods and services (the wage-price spiral), pushing inflation higher. If interest rates don’t trend downward, consumers are stuck with higher auto loans and pricey mortgage payments.

Banks that were expecting a lower rate environment on a faster timeline may have to rearrange their consumer and commercial portfolios. A higher rate environment means possibly lower economic activity and fewer consumer auto loans and mortgage originations. That says nothing for the commercial real estate markets, that might face refinancing or foreclosure. At the same time, if interest rates continue to ease heading into 2025 (on pace with another percentage point drop), these headwinds become less concerning.

Prediction is very difficult, especially if it's about the future!
- Niels Bohr (Nobel laureate in Physics and father of the atomic model)

While expectations might be directionally correct, it is very difficult to predict the true path of the Fed Funds rate. Bank managements need to be flexible, adapting their investment portfolios and lending practices to the variability of rate decisions and timelines.

Q: HOW WILL A TRUMP ADMINISTRATION IMPACT THE U.S. BANKING INDUSTRY?

A: Under Republican regulators, we anticipate shake-ups in the following areas:

Capital Rules: There may be efforts to dilute Basel III requirements, which currently mandate big lenders to hold more capital against potential loan losses. The proposed 9% additional capital requirement for large banks could be reduced, potentially freeing up funds for growth and capital return to shareholders in the form of stock buybacks or dividend increases.
Mergers & Acquisitions: Bank mergers and acquisitions (M&A) activity slowed in the past few years. High interest rates, fears of a recession, and weakened equity valuations caused an inhospitable environment for consolidation. Emphasis on anti-trust issues, combined with the 2023 regional bank failures, only served to intensify regulatory scrutiny. Changes in management of the country’s regulators, together with an increasingly favorable economic and interest rate climate, may accelerate consolidation within the banking sector, on the back of shorter approval timeframes and reduced regulatory scrutiny.
Fee Income: We will look to see how the regulators deal with some of the consumer protection initiatives like lowering or even abolishing the overdraft penalties banks historically charged. Some banks have already done away with most of these fee-earning parts of the business.

Q: HOW QUICKLY COULD THESE CHANGES OCCUR?

A: U.S. Federal bank regulators are especially busy in the waning days of 2024; for example, they just released payment service pricing details and asset thresholds in effect for all of 2025. Come the first of the new year, Federal regulators will be out in force meeting with various banking institutions – all under the Biden administration’s oversight. It will be interesting to see the tone and direction of change, after the new administration officially takes office in late January 2025, and ultimately installs new regulators.

That said, it’s important to note that significant changes in Federal Reserve monetary policy may take longer to materialize, as Jerome Powell’s term as Chair continues until May 2026. This could provide some continuity in overall monetary policy direction, even as regulatory approaches shift.

2024: STELLAR PERFORMANCE OF U.S. REGIONAL BANKS

SOURCE: SPDR S&P Regional Banking ETF, data through 12/04/24

Q: U.S. BANKS HAD STELLAR PERFORMANCE IN 2024; WHERE DOES THE INDUSTRY GO FROM HERE?

A: Bank managements are bullish about the prospects for 2025, pointing to a very promising operating environment. Optimism has already seen new heights in the lead up to the New Year.

There have been nearly a dozen balance sheet restructurings in December 2024 alone, including the likes of Dime Community (Polaris currently owns this company as of 12/31/24), Valley National, Flushing Financial and many more. The number of restructurings is immense, as banks take a hit on longer-dated securities that might be underwater and redeploy that capital advantageously.

M&A activity has sped up, on pace to see a 25% increase in deal count from 2023, with a number of $10 billion+ community banks announcing sales. The regulatory changes likely under the second Trump administration may offer a clearer path to regulatory approval for bank mergers. Brookline Bancorp and Berkshire Hills will be joining forces as they announced on December 16^th SouthState acquiring Independent Financial, and Independent Bank Corp. based in Boston acquires Enterprise Bancorp which was announced December 9^th. (Polaris owns Brookline, SouthState and Independent Bank Corp. as of 12/31/24.)

Mutual bank conversions are rare, with only 2–4% of banks converting in a given year. Yet 2024 is on a quick pace, with four completed and another four in the pipeline as of December 19, 2024. Motives for these conversions include growing, raising capital, diversifying loan portfolios, and potentially acquiring other banks or branch offices (in the future).

And we expect the industry will continue on its current trajectory in terms of M&A, securities restructuring, etc., fed by a number of macro-economic trends including: economic growth, reduced taxes, easing regulations (reducing the excessive costs of compliance); higher-for-longer interest rates (which allow for net interest margin expansion); possible favorable tax policies, including the extension of The Tax Cuts and Jobs Act; and loan growth due to domestic economic activity (on-shoring, re-shoring, infrastructure spend). Bank capital ratios are likely to come down in 2025 primarily due to 1) the implementation of the “Basel III endgame” regulations, which will result in a revised calculation of risk-weighted assets or 2) Republican regulators implementing looser capital requirements. In either scenario, banks may be able to hold less capital relative to their risk exposure; freed up funds are deployed for lending and investment, which can increase a bank’s return on equity.

Our job as alpha generators is two-fold: 1) to understand the solid fundamentals of banks and 2) to invest in companies in which we believe the true earnings power is not yet fully reflected in the current valuation of the business. We will monitor valuations throughout the U.S. banking industry, with careful focus on the regional banking market. As it stands now, the Invesco KBW Regional Banking (KBWB) group trades at 13x forward earnings. The last time this group traded at this valuation was in ’16-’17, when performance topped +38%. It will be an exciting 2025 as we expect to see business fundamentals improve, hopefully reflected in another year of solid performance.***

This interview was conducted with Sam Horn, Assistant Portfolio Manager, in January 2025. Mr. Horn initially joined the firm in 2012 and re-joined Polaris in August 2016 as an Analyst, after completing his MBA from the MIT Sloan School of Management. He was promoted to Senior Investment Analyst in January 2021, and became an LLC member in January 2022. He continues to work with an experienced research team, performing fundamental analysis of potential investment opportunities.

PERSPECTIVES & BLOGS

IMPORTANT INFORMATION: The views in this article were those of Sam Horn as of the article’s publication date (January 7, 2025) and may be subject to change. Information, particularly facts and figures, are dated and in many cases outdated. Views and opinions of Sam Horn expressed herein do not necessarily state or reflect those of Polaris Capital Management, and are not nor shall be used for advertising or product endorsement purposes. Polaris Capital is an investment adviser registered with the Securities and Exchange Commission. For more information about Polaris, please contact us at (617) 951-1365 or email Client Service.

Bullish on U.S. Bank Stocks: Look Forward to 2025

Samuel Horn

Bullish on U.S. Bank Stocks: Look Forward to 2025

Samuel Horn

ASSISTANT PORTFOLIO MANAGER

Bullish on U.S. Bank Stocks: Look Forward to 2025

Samuel Horn

ASSISTANT PORTFOLIO MANAGER

banks optimistic about regulatory trends, rate cuts and the U.S. economy

Q: TELL US ABOUT THE U.S. BANKING MARKET OF THE PAST FEW YEARS. HOW HAS THE INDUSTRY EVOLVED?

Q: WHAT IS YOUR PREDICTION FOR INTEREST RATES IN 2025?

Q: WHAT ARE THE MOST PRESSING CHALLENGES FACING THE U.S. BANK SECTOR?

Q: HOW WILL A TRUMP ADMINISTRATION IMPACT THE U.S. BANKING INDUSTRY?

Q: HOW QUICKLY COULD THESE CHANGES OCCUR?

Q: U.S. BANKS HAD STELLAR PERFORMANCE IN 2024; WHERE DOES THE INDUSTRY GO FROM HERE?

from the team at Polaris Capital...

from the team at Polaris Capital...

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