Large banks1 have been relative beneficiaries of the recent banking sector turmoil, as highlighted in their recent Q1 results. This was most evident in JP Morgan’s results which came in ahead of expectations and included a high level of profitability and a 10% upgrade on where they expect their Full Year 2023 net interest income (NII – the difference between the interest income it earns from its lending activities and pays out to its depositors) to be. In fact, they are the only US bank to raise NII guidance. The difference between their average (-3% quarter on quarter, q/q) and period-end deposit data (+2% q/q) also showed JP Morgan was a clear beneficiary of the deposit outflows from smaller banks following the recent Silicon Valley Bank (SVB) crisis.

Deposit trends stabilising

US bank deposits fell $350bn (-2%) in the three weeks in March following the failures of SVB and Signature Bank, with small bank2 deposits contracting 5% q/q, compared to large and mid-cap banks’ deposits contracting 1% and 2% respectively. However, subsequent Federal Reserve data suggests actions taken by the regulator have stabilised the situation, with managements noting that elevated outflows lasted only a few days during the SVB crisis. In its latest filing, PacWest noted it had seen deposit outflows again following negative headlines that it was “exploring all options”, however, we view this as bank-specific, with Western Alliance, another small-cap bank in the eye of the storm with technology exposure, noting deposits are up $1.8bn since the end of March.

Source: Company reports 1Q23.


Impact of higher funding costs on net interest margins

The increase in funding costs accelerated during the quarter with small banks seeing the largest rise. Their net interest margin3 was squeezed by 0.13% or 13 basis points (bps)4 and by 2bps for mid-sized banks5, while large banks saw their margins expand by 7bps. The shift in deposit mix away from non-interest-bearing accounts is a negative for net interest margins and is most evident at the smaller banks whose non-interest-bearing deposits fell significantly (370bps quarter-on-quarter); whereas it was only -50 bps for large banks. We expect this difference in funding costs between small and large banks to be increasingly apparent in subsequent quarters, reflecting a further shift in deposit mix.

No change (yet) in asset quality

The quarter showed resilient asset quality trends with minimal changes in non-performing loan ratios – the ratio of bad loans as a proportion of total loans – across large and small banks. Uncertainty as to the extent to which asset quality will deteriorate from here remains a key overhang on the sector, with commercial real estate (CRE) in particular focus. Feedback from management points to the potential for deterioration in CRE asset quality over time as loans come due for maturity. However, it is important to note the difference in CRE exposure in terms of underlying properties with multi-family apartment blocks and warehouses considered more resilient while office and retail remain under pressure.

Source: Company reports 1Q23.


Regulation to be harmonised

US bank capital ratios – measuring the funds a bank has in reserve against the risk-weighted assets it holds – remain healthy against current requirements, however regulations are set to be tightened as regulators assess recent bank failures and propose changes. Michael Barr, the Federal Reserve’s Vice Chair for Supervision, published his report on 30 April which called for lowering the threshold for greater regulatory scrutiny from $250bn in assets to $100bn along with other measures aimed to reduce the risks that banking customers are exposed to. Positively, the report stressed that the proposed rulemaking will not be rushed and instead will follow the normal multi-year process of phasing in the new requirements, allowing an orderly transition for those organisations affected and significantly reducing the risk of forced capital raises. Nonetheless, as the largest banks already comply with stringent liquidity requirements and include unrealised losses in their capital ratios, the cost of the increased regulatory burden will be felt most by small and mid-sized banks.

Fund positioning

The strategies managed by the Polar Capital Global Financials team had already seen a material reduction in US bank exposure over the past year, in particular -16% for the Polar Capital Global Financials Trust, and most of that was in the US small and mid-sized banks on the expectation that the rise in margins due to higher interest rates was reaching a peak. While we currently have no small bank exposure in the Polar Capital Global Financials Trust, our analysis suggests small bank valuations are already pricing in both lower interest rates and a weaker asset quality environment. Consequently, we see strong recovery potential in high quality, relationship-based smaller banks – that will use the current turmoil to take market share and reinforce their competitive position – but are sitting on the sidelines until there is greater visibility on regulatory changes and asset quality.

Source: Bloomberg; 26 March 2023. *EPS = earnings per share.


1. ‘Large’ refers to JP Morgan, Bank of America, Citigroup, Wells Fargo.

2. ‘Small’ refers to East West Bancorp, Western Alliance Bancorp, Comerica, Webster Financial Corp, Zions Bancorp. These have reported 1Q23 results and we feel are representative of small-cap banks.

3. Net interest margin = a bank’s net interest income divided by loans and securities.

4. 1 basis point is 1/100th of 1% (13 basis points is 0.013%).

5. ‘Mid-sized’ refers to PNC Financial Services, US Bancorp, Trust Financial Corp, Fifth Third Bancorp, M&T Bank, Regions Financial Corp, KeyCorp, Citizen Financial Group.