A Gloomy Outlook for Banks

Despite the prevailing pessimism surrounding banks, certain corners of Wall Street remain optimistic and believe there may still be potential for growth in the sector.

This outlook, however, might be hard to digest for some investors. Contrary to expectations, higher interest rates have only exacerbated existing problems for banks.

With the decline in value of their bondholdings, bank balance sheets are burdened with significant unrealized losses. Additionally, the demand for loans has dwindled as potential borrowers are deterred by the prospect of higher rates. This decline in borrowing activity comes at a time when banks are under pressure to offer more competitive interest rates on deposits, or risk losing customers - a situation that proved disastrous for banks like Silicon Valley Bank earlier this year. As a result, the gap between what banks earn from their assets and what they pay on their borrowings has significantly narrowed.

To add to the industry's woes, banks are now grappling with increased regulatory scrutiny following the failures of several regional banks six months ago. This has translated into higher capital requirements and costs for banks.

All in all, the current state of the sector is far from ideal. The SPDR S&P Bank ETF (ticker: KBE) has experienced a decline of 23% this year, while the SPDR S&P Regional Banking ETF (KRE) has witnessed an even more substantial drop of 33%. However, the forward-looking nature of the market suggests that it has little faith in any potential recovery for the banks at this point.

The Resilience of Banks: A Promising Investment Opportunity

Despite the current negative sentiment surrounding banks, industry experts remain optimistic about their future prospects. Chris Kotowski, an analyst at Oppenheimer, acknowledges that investor psychology towards banks is currently at an all-time low. However, this is not unfamiliar territory for the sector, as banks have successfully navigated challenges in the past by adapting their business models to ensure profitability and appeal to investors.

While proposed changes to capital requirements may temporarily reduce industry returns, Kotowski emphasizes the importance of banks managing themselves to earn a reasonable return on their equity in the long run.

Other analysts echo this sentiment and suggest that much of the sector's negative outlook is already factored into current valuations. They believe it is now an opportune time for investors to seek out undervalued opportunities.

David George, an analyst at Baird, notes that present valuations imply permanent profitability impairment, a scenario he considers highly unlikely. To identify potential bargains, George assesses banks based on their projected preprovision net revenue (PPNR), a measure of revenue before accounting for credit losses. His analysis reveals that many banks are trading at historic multiples significantly lower than their actual worth.

George specifically highlights Capital One Financial (COF), Citizens Financial (CFG), Comerica (CMA), U.S. Bancorp (USB), and Truist Financial (TFC) as banks that offer favorable risk/reward ratios and are attractively priced based on his metrics.

While banks may not currently generate excitement within the investment landscape, it would be unwise to overlook their potential for too long.