Too small to worry eclipses too big to fail

Forget about the too-big-to-fail banks; investors have fallen in love with their too-small-to-worry-about cousins.

It’s easy to see why. Regional banks have fewer issues with those pesky capital requirements, mercurial fixed-income trading results or the chance of waking up to another scandal in the news. Also, there are the deals: Royal Bank of Canada’s purchase of City National Corp. and BB&T Corp.’s bid for National Penn Bancshares are among takeovers that have awakened animal spirits for this group.

Then there’s that whole Federal Reserve interest rate increase looming somewhere out in the near future, which has made these stocks somewhat of a haven. The little banks arguably have more to gain from higher rates and steepening yield curves because their business models rely much more on simply taking deposits and making loans, as illustrated by net-interest income.

Here are the proportions of net-interest income to net revenue for some of the regional banks with most at stake: National Bank Holdings, Signature Bank New York, Western Alliance Bancorp, Investors Bancorp, Cathay General Bancorp and PacWest Bancorp. The universal banks, JPMorgan Chase, Bank of America, Wells Fargo and Citigroup, have much more diverse businesses, so net-interest income is less important to them.

With the case for interest rate increases getting stronger by the day, the KBW Regional Bank Index has been on fire lately. It jumped 7 percent last week, including a 3 percent surge after the employment numbers on Friday, and has returned 16 percent year-to-date. The index, and an exchange-traded fund tracking regional banks, reached the highest level since 2007 last week. Both were down about half as much as broad market indexes on Monday. 

The question now is whether investors have fallen a bit too hard for these little banks. The regional-bank index is trading for 1.5 times book value, or the value of assets minus liabilities. That level would have seemed like a bargain before the financial crisis but feels expensive now because the confidence in the value of bank assets isn’t what it used to be. The ratio is creeping back toward the highest level it has seen since the market peak in 2007.

Of course, smaller banks tend to have greater opportunities for growth than their larger counterparts. Yet even when taking that into account, the smaller firms appear to be richly valued in terms of their PEG ratios. The PEG takes a company’s P/E ratio and divides it by its estimated earnings growth, and conventional wisdom is that the company is fairly valued if the resulting reading is close to 1.