Bank stocks' revival depends on relaxed rules, deal recovery

Bloomberg

Loosening regulations, the steady drumbeat of dealmaking, elevated interest rates: It's a recipe for U.S. banking stocks shares to rip higher. 

Lenders have been an underdog in the broader market's blistering rally for the past couple years. Now, with stress-test results and the easing of bank capital rules on the horizon, many on Wall Street see a chance for the sector to break out.

"You have a triple play when it comes to banks," Wells Fargo's Mike Mayo said. The banking analyst pointed to the biggest regulatory inflection in three decades, improved operating leverage and revenue growth. "So long as there's no recession, it's game on for bank stocks, giddy up!"

Mayo, who correctly called for a rerating of banks last year, predicts big gains ahead. His call was dealt a temporary setback in April when President Donald Trump's tariff plans shook markets. Those fears have started to dissipate with U.S. equity benchmarks back near all-time highs.

For the banking sector, last year's 33% jump was a much-needed rebound after two years of losses. The KBW Bank Index is still more than 7% below its 2022 all-time high while a technology-fueled rally has driven the S&P 500 up by a little over 30% in the same period. The biggest American bank, JPMorganChase, is already clearing a path for peers after closing at a record high on Wednesday. 

Even if the rest of the market starts slumping, bulls say banks can still come out ahead. Take the geopolitical tempest flaring in the Middle East. While simmering tensions threaten to reignite market anxiety, the last bout of volatility only led to more trading for banks that were already notching record revenue.

Less stress

Investors will be looking for signs of easing capital restraints on Friday, when the Federal Reserve releases its annual stress test results at 4:30 p.m. 

Ian Katz, a managing director at Capital Alpha Partners in Washington, expects all the banks to pass the test, giving the group leeway to pick up the pace of buybacks and dividends. The Fed plans to reduce the restrictiveness of future tests.

"The expectation is that the 22 banks tested will perform well, in part because the severely adverse scenario is seen as a bit less rigorous than last year's," Katz wrote in a note. 

Broad regulatory changes are also afoot. The Fed unveiled a plan Wednesday to decrease what's called the enhanced supplementary leverage ratio, which requires banks to hold a certain amount of capital relative to their assets.

Fed Vice Chair for Supervision Michelle Bowman backs the plan to revise the capital rule. Bank mergers are also expected to pick up under Bowman. She's expected to take a more favorable approach to tie-ups after the Biden administration's scrutiny of deals kept many companies on the sidelines. 

Morgan Stanley sees "faster and more transparent M&A approvals" under Bowman, analysts including Betsy Graseck wrote in a recent note. "Regulatory clarity is a critical unlock for M&A."

Deal speculation is already heating up. On Monday, Northern Trust vowed to stay independent after a report that Bank of New York Mellon was interested in a possible megadeal.

Hazy outlook

There are of course risks that money centers will continue to miss out on the larger race to all-time highs. Wednesday's report from Jefferies Financial Group Inc. gave an early read on the sector ahead of July quarterly earnings. The New York-based firm's investment-banking and capital-markets revenue was hurt by economic and geopolitical turmoil. JPMorgan, Bank of New York Mellon, Citigroup and Wells Fargo will report their second-quarter earnings on July 15. 

The Fed's path is far from clear. And while banks usually benefit from elevated interest rates, the spate of bank failures in March 2023 that toppled Silicon Valley Bank serves as a cautionary tale of how high rates can pummel financial liabilities.

Smead Capital Management is currently a buyer of bank stocks but is hyper-focused on net interest margins, according to Cole Smead, its chief executive officer. "The higher the nominal long-term rates go, the more it hurts the deal making business and the wealth management business," he said. 

Regional banks with less income derived from deals are spared the worst of those pressures, according to Smead. Baird analysts also favor regional lenders as they see limited upside for megacap names given recent strength.

Past the breakers

Morgan Stanley's Graseck remains bullish on money center banks. She raised her price targets this week, citing an acceleration in dealmaking and new offerings.

So far, the Fed has kept borrowing costs steady to guard against a resurgence in inflation. Hard economic data — from retail sales figures to labor reports — have largely held up this year, further delaying any need for sharp easing.

"Higher for longer is good for bank earnings as long as they don't induce an economic downturn and/or credit problems," HSBC analyst Saul Martinez said. 

To Wells Fargo's Mayo, once the market gets past tariffs, taxes and geopolitics, investors will recognize the sector's appeal. 

"The demand for banks to function as an intermediary has increased — if you ever were going to talk to your banker, it would be now to set up plans and contingency plans," Mayo said. The rally at the start of 2025, "was just a dress rehearsal for what you're likely to see over the next year."

LOOKING FOR MORE? Is regulatory independence on the way out?