Bank stocks have been pounded in 2023, as the Federal Reserve’s aggressive rate hikes slowed lending, cratered bond prices and encouraged deposit flight. Given the leverage in the banking business and the ability for a bank’s deposits to evaporate in days – see Silicon Valley Bank – it’s understandable that investors may be just a bit nervous about buying bank stocks.

While medium-sized regional banks got a lot of the bad press in the first half of the year, the carnage has been broad-based, with even the stock of large banks such as Bank of America and Wells Fargo getting hit. But with the Fed signaling that further rate hikes are on the way, is now the time to buy bank stocks, even if they are trading at cheap valuations?

“The well-known struggles of some high-profile regional banks have caused the entire sector to trade down on fears that similar issues will afflict other banks,” says David Waters, CFA, president, Alluvial Capital Management. “Yet there are numerous banks that operate differently.”

So it could be a good time to buy, say Waters and other professional bank investors. But you’ll need to pick your spots, since each bank’s exposure to the environment can differ markedly.

Rapidly rising rates have maimed banks

Generally speaking, rising rates are good for banks. Banks are able to generate a higher return on their money, can often hold the rates on deposits steady or raise them only slowly and increase the spread on their funds. But the last 15 months have been anything but typical.

The Fed has engaged in one of the most rapid rate increases in history, boosting rates from near-zero in early 2022 to more than 5 percent by mid-2023. And more may be on the way.

That’s after a period where banks and investors got pretty comfortable with near-zero rates in the prior two years, as the Fed slashed rates to help prop up an economy reeling from the COVID-19 pandemic. And it follows a period of more than a decade when markets got still more comfortable with a benign rate environment in the wake of the global financial crisis.

But now skyrocketing interest rates have really crimped banks on a number of fronts, giving them relatively little time to adjust their balance sheets:

  • Rising rates have made loans more costly which slowed lending.
  • Rising rates have made deposits more expensive, as depositors search out higher yields or take their money to higher-yielding and safe alternatives such as Treasurys.
  • Rising rates have decreased the value of bonds and mortgage-backed securities, hurting the banks’ supply of emergency capital.
  • For the aforementioned reasons, rising rates also encouraged deposit flight that resulted in some of the all-time largest bank collapses.

And the Fed has all but assured markets that more increases are on the way, at least as long as inflation remains a problem, according to statements from its June meeting.

The renewed belief that rates would move still higher helped throw a major fund tracking mid-sized banks – the SPDR S&P Regional Banking ETF (KRE) – into a tailspin. After falling in March, the fund had been rising since early May, as the market began to settle down following several high-profile bank collapses and increasing suspicion that rates would soon move lower.

Of course, not only the medium-sized banks were hit. The largest banks as well as the small community banks felt the force of investors dumping their bank stocks.

But even with cheaper bank stocks today, is it time to buy?

Bank stocks look cheap, but choose carefully

Professional bank investors see opportunity in the wreckage, if you’re willing to pick through it.

“Banks have started to understand how to operate in a higher rate environment, and for the most part have realized that rates aren’t going to quickly fall like many suspected,” says Nate Tobik, founder of and author of The Bank Investors Handbook.  “Because of that, they’ve figured out how to adapt to this environment.”

Tobik thinks it’s an attractive time for investors looking to buy bank stocks, but with a caveat.

“The caveat is that there are still a lot of banks that, when you take their mark-to-market losses on securities and mark their loans to market, are left with no equity or negative equity,” he says.

That is, rising rates have hammered their bond portfolios and the real value of their loans, leaving them with less capital, even negative capital, when you adjust for the declines.

“For now regulators are taking the stance that they can earn their way out of this,” he says. “As an investor that needs to be kept in mind, there is no merger and acquisition savior to boost the stock price, it’ll be a slow grind.”

Mergers and acquisitions have been one of the traditional ways for investors to profit in the bank sector. The industry has been consolidating for four decades, as rivals gobble each other up. Still, investors can make money in banks as the environment normalizes.

“Bank valuations are anticipating quite a bit of stress ahead,” says Waters. “But eventually, the market will begin looking past it. If investors insist on waiting for the ‘all clear’ signal of moderating interest rates and dissipating recessionary fears, they may miss buying opportunities.”

Other investors are less optimistic about the current moment, but still see some opportunities.

“In general, I feel that now is a lukewarm time to buy banks,” says Don Hensel, a private bank investor and retired commercial banker. “Although banks trade at a discount to many other sectors, it’s difficult to see how they will grow profits.”

Hensel points to falling deposits and rising salary and technology costs today compared to “rising bond yields and stronger loan pricing [that] will eventually boost revenue.”

What features should investors be looking for in a bank stock?

“I think it is a good time to buy some bank stocks,” says Waters, emphasizing the word “some.”

The interesting ones? “These have low-cost, sticky deposits, well-diversified loan books with high underwriting standards, and they didn’t go wild buying long-duration securities when interest rates were at their nadir,” says Waters.

What other features are professionals looking for in their bank investments?

  • High quality: “Investors should focus on high-quality institutions that have been tarred by the general stigma around banks, not scratch-and-dent cases that made bad decisions in recent years and are now struggling to correct course,” says Waters.
  • Variable-rate loans: “If a bank has a portion of its loan book floating, then they’ve been able to protect their margins,” says Tobik. “The types of loans that would be ideal here are commercial operating lines that are based on a benchmark rate, or commercial real estate that’s variable.”
  • Growth opportunities: Banks that can grow their lending through either regional expansion or product expansion could continue to add to earnings in this environment, say experts. Banks that have business lines such as trust business or SBA origination that generate fees and are less exposed to the rates cycle can help diversify things, too.
  • High insider ownership: “Insist on high insider ownership,” says Waters. “Why should anyone invest in a bank where the people closest to it will not? I want management to feel the pain that shareholders feel when a bank is struggling.”
  • Stick to proven managers: Management teams that have “seen this movie before” and thrived are a better pick than those going through it all for the first time.
  • Attractive adjusted valuation: In a period where bank balance sheets have been hobbled by rising rates, it’s important to adjust valuations to understand exactly what you’re paying. “Look for banks that have an attractive valuation after factoring in all mark-to-market losses,” says Tobik.

Banks with several or all of these factors are available now in the market, say experts.

“With so many excellent banks trading cheaply, there is absolutely no reason to go dumpster diving,” says Waters.

Are small banks more attractive than large banks right now?

Small banks have often been popular for a number of reasons, but the bank’s size is not something that necessarily indicates it’s a good buy right now. Small banks can just as easily be in the same trouble as their larger rivals. Size is no protection against boneheaded decisions.

Still, small banks may be especially attractive right now, given that they often trade at discounts to larger banks in normal times and they’ve undergone further declines along with the sector.

“I have always been an advocate for small banks,” says Waters. “For their growth potential, for their potential to acquire or be acquired, for their more frequently mispriced shares.”

But the largest banks have something that small banks don’t: government protection. Amid the March collapse, many depositors moved money from banks unlikely to have such protection, causing something of a run on some regional banks. But banks perceived as too big to fail – whose depositors would likely be made whole in the event of a failure – were the beneficiaries.

“They enjoy an implicit government guarantee and will likely see their share of national deposits continue to increase,” says Waters, who thinks big banks can be attractive here.

Big banks also have another thing that the little guys don’t: scale.

“Big banks certainly look attractive in this environment, because they have the scale to stomach higher staffing, technology and compliance costs,” says Hensel.

As for the mid-size regional banks that have felt much of the brunt of the recent turmoil?

“I’m not surprised that the regionals have been seriously marked down,” says Hensel. “Under proposed regulations, they will be required to keep 20 percent more capital on the balance sheet. I also feel that there will be accompanying regulatory burdens – such as stress-testing – that will really goose costs.”

Hensel says he’s on the hunt for “regional banks where the ‘baby was thrown out with the bathwater.’”

Whether they go small, medium or large, investors must assess the bank’s balance sheet and understand its rate exposure, among other details, before they decide to invest. Those unwilling to do such work may be best served buying a bank index fund, which offers the consolation of diversification to reduce risk.

Bottom line

Investors looking to get into bank stocks following their declines in 2022 and 2023 should be taking a longer-term perspective on their investment, especially with potentially more risk on the way in terms of higher rates. Still, a sector-wide decline makes it a particularly good time to sift through the industry and find the good operators and stocks that have been unfairly punished.