Why Do So Many Regional Banks Have a Very High ROE?

[ContrarianValue44]

Hello, I am wondering if anyone has any insight into how come there are 23 regional banks that have a 15% or higher ROE, 3 of which (First Savings Financial, Merchants Bancorp, and Meridian Corp) even have a 20% or higher ROE, while most major banks (such as Bank of America, Citigroup, Wells Fargo, JP Morgan, etc.) are struggling to even get to a 10% ROE right now. Is this a result of these regional banks facing less competition? Is it because these regional banks are smaller so they have less regulations and capital requirements forced upon them? Thanks in advance for your insights!

Also do you think that these high ROE regional banks that are trading at below 10x P/E are possibly an attractive investment. Thanks in advance!

[Cigarbutt]

This is interesting.
i don't hold banks now but have in the past (including smaller ones) and may again in the future.
With regional banks (like real estate) there's the possibility that local knowledge of the market advantage may be superior to the economies of scale of the Big Banks.

In general since the GFC, smaller, regional and 'community' banks have caught up to the big banks because their net interest margin has held up better, in large part because smaller banks have more flexibility in originating and holding real economy loans with larger banks being fed cash (parked at the Fed, yielding low IOER) and built-in expectations that a large part of their assets will be low-yielding 'safe' government securities.

If you're interested in banks and the industry in general, the FDIC regularly releases data which can be helpful before going for specific targets. Examples below: 1-their last Q4 2020 release (see pages 19-26 for community banks; there is also a section showing ROAs and ROEs segmented by asset size) and 2-something they did on community banks.
https://www.fdic.gov/bank/analytical/quarterly/2021-vol15-1/fdic-v15n1-4q2020.pdf

https://www.fdic.gov/resources/community-banking/report/2020/2020-cbi-study-full.pdf

i just spent about 3 minutes on the names you mention and Merchants Bancorp MBIN looks interesting.

[TwoCitiesCapital]

I haven't seen him for a minute, but oddballstocks on this forum is an expert on financial institutions (particularly small ones). Hopefully he still frequents and can opine.

My general thoughts are:
1) Less onerous regulation and capital requirements since they're not SIFIs means they can earn more with less capital and fewer compliance costs
2) Less competition in smaller markets means higher margins available for the handful of participants in those markets
3) As mentioned above - they know the market and can be more opportunistic with pricing and risk

[thepupil]

I'd be careful extrapolating one year. In First Savings case, they feasted upon mortgage banking. In general, small banks might have fee producing businesses that are a larger % of the earnings and therefore have high ROE's.

[quote]Noninterest Income.  Noninterest income increased $87.2 million, or 199.0%, from $43.9 million for the year ended September 30, 2019 to $131.1 million for the year ended September 30, 2020.  The increase was due primarily to an increase in mortgage banking income of $84.8 million. The increase in mortgage banking income is due to production from the secondary-market residential mortgage lending segment that commenced operations in April 2018. Net gains on the sale of loans guaranteed by the SBA also increased $1.1 million for 2020.  In 2019, noninterest income increased $30.6 million, or 229.9%, from $13.3 million for the year ended September 30, 2018 to $43.9 million for the year ended September 30, 2019.  The increase was due primarily to increases in mortgage banking income and real estate lease income of $30.7 million and $589,000, respectively.  These increases were partially offset by a decrease in the net gain on sale of loans guaranteed by the SBA of $924,000.  The increase in mortgage banking income is due to production from the secondary-market residential mortgage lending segment that commenced operations in April 2018.  The increase in real estate lease income for 2019 is due to the acquisition in October 2018 of a commercial office building that now serves as the Company’s new corporate headquarters, a portion of which is leased to other tenants.

[Junto]

Even with Merchants Bank, it was secondary market lending that really drove their results. Between PPP loan volume and Secondary Market loans, this drove regional banks much more than the mega banks. 

[ContrarianValue44]

@Cigarbutt @TwoCitiesCapital @thepupil@JuntoThanks everyone for your insights, I really appreciate your commentary. I did not realize that I was extrapolating results to such an extent, you're absolutely right. I'm curious though as to why thepupil and Junto believe that the ROE will return back to what it was before their was a boost in mortgage banking and secondary market loans (I understand that the PPP loans will dry up though). If they stay at today's levels, shouldn't these banks NIM and ROE stay at around today's levels or even increase in a few years with the anticipated increase in interest rates? Thanks in advance, looking forward to hearing your ideas!

[thepupil]

I don't have any insight and haven't looked into the companies. Just gave them a 5 minute look to see why their ROE inflected to much higher from the prior years. 

In general, mortgage banking is quite cyclical given refi volumes are related to the refi incentive (difference between current rates and rates that mortgage borrowers have) as well as home purchase volume. But again, I haven't looked into any of these specific names. 

[ContrarianValue44]

Great thanks, I really appreciate the explanation!

[CapriciousCapital]

I'll add that in normal times, globally systemically important banks have higher capital requirements which reduce ROE. Ultimately ROCE looks a little better when GSIBs issue preferred stock.

[LearningMachine]

The higher capital requirements also provide higher buffer for absorbing losses. 

You have to decide for yourself if you want to be leveraged 10x or 15-20x. 

The latter might give you higher ROE but also arguably at higher risk of loss of capital. 

That said, leverage is not the only risk.  There are also other big risks, e.g. what assets banks have, what other risky activities they are exposing themselves to, interest-rate risk, credit quality risk, etc..  So, you could still have a big bank with high risk.

Overall, I'd rather play it safe with low leverage and also lower other risks, especially when risk/reward will be multiplied by 10-20x.

Edited April 2, 2021 by LearningMachine

[ContrarianValue44]

Thanks for the help and feedback everyone, it is greatly appreciated!