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In This List

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One-off credit issues could torpedo US regional banks' Q3 earnings season

With markets concerned about a potential turn in the economy, one-off credit issues could weigh on U.S. regional banks' third-quarter earnings season.

Margin pressure will be the top issue for analysts across the entire banking space, from community banks to money-center institutions. While margin will be a primary focus for regional bank earnings, the group also has to worry about potential contagion from credit concerns as "one-off" issues appear to be on the rise.

Since regional banks tend to have higher sector concentrations, on a relative basis, than large national banks, they are more vulnerable to a sell-off out of their control. For example, if one bank reports a credit loss from energy, the market immediately looks for other lenders with exposure to the energy sector.

"And then everyone gets thrown under the bus, no matter if the risk is real," said Collyn Gilbert, an analyst for Keefe Bruyette & Woods. She cited franchise lending and energy loans as two potential areas of concern.

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Other analysts also tabbed energy as a top candidate for third-quarter issues. Bankruptcies are on the rise for oil-and-gas drilling companies, and credit ratings agencies see financial distress increasing for both drilling and pipeline companies as oversupply drives down the price of gas.

Texas-based banks were behind several credit-related headlines in the second quarter. Texas Capital Bancshares Inc. charged off two energy loans in the second quarter and downgraded a third to "special mention" classification. Cadence Bancorp. also reported a spike in charge-offs and nonperforming loans, including an energy loan alongside restaurant and other credits. Other banks have also tabbed restaurant loans as a source of stress.

David Feaster, an analyst for Raymond James, said that while he expects actual losses to remain low, the market could sell off energy-focused banks as a result of loan downgrades — a designation that a credit has deteriorated, typically made before a charge-off. Even if a bank has zero credit issues, a downgrade of an energy loan at a peer bank could be enough to weigh on the whole sector, he said. For long-term investors interested in fundamentals, banks' pain could be their gain.

"In 2016, some of these banks lost more in market cap than they had in their entire energy portfolio," Feaster said in an interview. "That's the kind of irrationality that can happen — and that could create a buying opportunity."

Rates still top of mind

While analysts remain concerned about credit quality slip-ups, they expect actual losses to remain near their historically low levels. Analysts said banks' net interest margin figures and their outlook for rates will be far more important in assessing fundamental performance. The third quarter could be a particularly tough one with a potential double-whammy of falling asset yields and rising deposit costs.

"I think, in general, it's going to be a tough quarter. It's going to be led by what we think is pretty severe margin pressure," said Peter Winter, an analyst for Wedbush Securities. "The margin is getting assaulted on all fronts."

Loans are often priced relative to a rate benchmark, such as Libor, so the Federal Reserve's rate cuts are immediately reflected in those assets. Meanwhile, a bank might be reluctant to lower what it pays customers on their deposits for fear of losing the client. In fact, banks might feel market pressure to raise deposit rates despite the Fed's rate cuts; just last week, two financial technology startups announced plans to offer cash management accounts that pay 1.6% and 2% on balances.

KBW's Gilbert said that her team's projections assume higher funding costs "almost across the board" in the third quarter before banks can realize some relief in the fourth quarter.

"The speed and frequency of rate reductions might not take hold as quickly as we were thinking," Gilbert said in an interview. "We're still hearing 2[%]-handles for business accounts, so that's a little unsettling."

Raymond James' Feaster also expressed concern about commercial-focused banks and said that he would be looking for earnings commentary on exception pricing for those banks' business clients.

The rapid switch to a falling-rate environment could benefit banks that had struggled when rates were rising — namely, ones that were more reliant on time deposits or brokered deposits. As rates decline, those banks should be able to lower their funding costs while peers with more noninterest-bearing deposits will have scant room to lower costs, Winter said.

"The banks that had the highest deposit costs in a rising-rate environment are the ones that have more leverage to lower deposit costs now," he said.

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