The Rate Also Rises

This article is part of a short series of articles on strategic movements among regional banks. Among these articles, I may feature specific banks or call out trends. I have no relationship with any of the banks I will highlight, though I have spent time working at a large commercial bank. I will note when I hold a position in a company or ETF or plan on taking a position.

The Rate also Rises

SunTrust Banks, Inc. (NYSE:STI)

Market Cap ~ $21B

In my prior article, I discussed what I see as a growing trend in the commercial banking business. The trend towards what I call universal regional banks is fascinating because it calls to mind the trends of the 1990s and early 2000s in commercial banking. I find it highly likely that the better-managed, larger regional banks expand their businesses and brands to gain a national presence. Some may do this out of a desire for growth and scalability. Others may do it because they view this as mandatory for survival. Either way, strategic consolidation will likely result from the competitive pressures of the current market climate and long standing industry headwinds.

An archetypal example of the consolidation process among regional banks is Bank of America (NYSE:BAC) in the 1990s and 2000s. The process often occurs as follows: A regional bank grows through strategic acquisitions of regional banks and brokerages when they are weakened. This regional bank becomes a universal regional bank with a large regional retail banking presence, a strong commercial banking franchise, and a robust middle market investment banking practice. When opportunity knocks, a well managed universal regional bank has the opportunity to save the day by acquiring poorly run commercial banks or investment banks and gain the scale necessary to compete with the money center banks.

The growth from regional to super-regional to universal regional, to universal bank might seem slightly far-fetched for some of the candidates I will discuss in this series, but not that long ago, Bank of America and Wells Fargo (NYSE:WFC) were regional banks headquartered in small cities. Bank of America is still headquartered in Charlotte.

This brings me to the first regional bank I will analyze that has transformed its model into a universal regional bank: SunTrust Banks, Inc. (STI)

SunTrust has been steadily strengthening its consumer and commercial banking divisions over the last several years. Last quarter, the bank holding company efficiency ratio continued to improve with a full year 2014 target of 64% and a long-term run-rate efficiency ratio of 60%. SunTrust made major improvements in efficiency over the last 6 quarters, and we see SunTrust as being serious about maintaining efficient operations. The 60% level is a reasonable target for a deposit reliant commercial bank, and while we might contend that there is still likely room to improve the efficiency ratio by reducing costs, we agree with management that the best drivers of improving the efficiency ratio remain improving the top line.

In terms of growing revenues on the consumer lending business, there are several drivers to consider going forward. SunTrust will most obviously benefit from rising rates. They currently have low cost deposit bases which has been a driver of net interest margin (NIM) improvement in many commercial banks over the last 2-3 years. SunTrust will be a major beneficiary as rates rise and banks can drive higher net interest income.

Rising rates will likely stifle the mortgage refinancing market over the next several years. The broad effects of this are several: SunTrust will not have as much loan originations, resulting in less fees for originations and for selling off guaranteed loans. However, SunTrust, like many other banks, has been the victim of refinancing on their held for investment (HFI) loans. As such, SunTrust will likely see lower pre-payments of mortgages, but also lower non-interest income than it has seen over the last six quarters. Overall, the negative effects of rising rates will likely be somewhat muted, but definitely seen in the mortgage book as mortgage behavior begins to normalize to a new run rate level.

All of this said, these predictions are at the mercy of Federal Reserve policy and as such, SunTrust has no control over them.

Sunny-side Up

There are, however, levers of growth that SunTrust management has a bit more control over. Many of investment banking activities are not nearly as interest-rate reliant. Over the last several months, SunTrust has been making significant efforts to strategically grow its wholly-owned investment banking subsidiary, SunTrust Robinson Humphrey (STRH). SunTrust Robinson Humphrey is a full-service corporate and investment bank that focuses on middle market companies. SunTrust has grown its corporate and investment bank in a relatively organic manner over the last several years, noticeably ramping up that process over the last six months by making several important hires.

While SunTrust can improve the overall firm’s efficiency ratio by growing its investment banking division, the growth of a strong investment banking division can also strengthen its commercial and consumer businesses. By bolstering its credentials as a universal regional bank, SunTrust can strengthen its brand regionally and introduce it to the national scene.

The reduction in investment banking activities among the large money centers and universal banks has led a renaissance for boutique investment banks (e.g. Moelis (NYSE:MC), Evercore (NYSE:EVR), Centerview, etc.) and the rise of small kiosk firms (e.g. Paul J Taubman). The role filled by regional middle market investment banks is at risk of being hemmed in by the bulge-bracket firms and squeezed by small boutiques. However, I believe that universal regional banks have the opportunity to maintain and even gain share in the middle market space through focused thought leadership in specific industries.

SunTrust Robinson Humphrey seems to have taken this strategy to heart by spending the last several months bolstering its equity and debt capital markets, sales & trading, and research divisions through strategic hires across the United States (herehere and here). Indeed, SunTrust Robinson Humphrey has expanded far beyond the footprint of the retail bank. How long until the commercial bank expands to meet the needs of clients in the investment bank? How long until the retail footprint follows?

Suffice to say that with recent growth in SunTrust Robinson Humphrey, executives at SunTrust are signaling their ambition to create a full-service bank within the company’s current footprint. Not only does SunTrust have the potential to scale nationally, executives may have the ambition to do so as well.

Overview and Caveats

One key factor I have not yet mentioned, but that one should consider when evaluating SunTrust is the bank’s capital ratios. SunTrust is currently well capitalized as of June 30, 2014, with a Tier 1 common equity ratio of 9.72%, Tier 1 capital ratio of 10.66%, and a total capital ratio of 12.53% (per the 10-Q filed 08/06/2014). Given the fact that SunTrust gained approval to double the quarterly dividend this year after the most recent CCAR process, the current levels of capital should position the bank strongly going forward with adequate capital to manage most market conditions.

The main headwind that I see as a potential near-term concern for SunTrust is a deterioration of loan quality in the auto loan book. Auto loans have become a major growth engine for regional banks over the last 2-3 years, as borrowing and repayment habits of American workers shifted after the Great Recession such that repayments of car loans became major priorities. Should customer payment habits change, this could create material financial issues for SunTrust and several other regional banks.

While I believe that there is decent upside in SunTrust, I would wait for the right price to buy shares of this business. I believe that SunTrust has the capacity to grow assets and footprint significantly over the next decade. The trick, as always with banking, is to do so profitably. After all, banks that simply dilute shareholders to create behemoths are rarely alpha generating investments. The past several decades have shown that while excellent banks can find economies of scale, poorly run banks that grow too large soon find themselves with crippling diseconomies of scale.

While the history of Bank of America may not repeat itself, I believe that SunTrust can rhyme. The question is not, however, can SunTrust become a universal regional bank, or even if it can become a national or international universal bank. The question that remains – can SunTrust do so profitably?

This article is an initiation of coverage. I will follow up with more fundamental analysis and valuation in a future article.

I hold no positions in STI.  I do not anticipate taking any long or short positions within the next 72 hours
I am not a Registered Investment Advisor.  This should not be considered investment advice. This is purely an expression of my opinions.

Character: The Fundamental Basis Of Business And The Future Of Finance

House of Morgan

Observations Concerning the Future of the Financial Industry

This article is the first in a series analyzing competitive trends in the financial services industry. Among these articles, I may feature specific banks or call out general trends. I have no current relationship with any of the banks I will highlight, though I have spent time working at a large commercial bank. I will note when I hold a position a company or ETF or plan on taking a position.

On Banking

In the 2011 Berkshire Hathaway letter to shareholders, Warren Buffett outlined the simple but universal rule: “buy commodities, sell brands” is one of the best ways to run a profitable business over the long term. This is the fundamental principle underlying finance. Banks are brands and finance – money and credit – is the ultimate commodity. What separates Goldman Sachs (GS) and Morgan Stanley (MS) from bucket shops (other than billions of dollars in shareholder equity)? The difference between them is their brands and the confidence and implied competence that these provide.

As interstate banking barriers have fallen and technological innovations allow greater scalability of retail and commercial footprints, I contend that we will see market divergence in commercial banking. As large banks are able to invest in new technologies that reduce costs and improve customer service, it is likely that the emphasis on brand and experience will create a strong competitive moat. A handful of large national banks will dominate commercial banking (with small community banks and credit unions maintaining a significant niche) and will play a powerful role in the investment banking world. Furthermore, the traditional broker-dealer/ investment bank business models will continue to diverge.

Commercial Banking

Net Interest Margin ((NIM)) based business are poised to thrive should the Federal Reserve raise interest rates significantly over the next 3-5 years. This is due to the simple mechanics of interest spreads in commercial banking. The cost component of efficiency ratios among regional banks and balance sheet reliant money centers will likely to improve as well – the financial crisis allowed banks to justify trimming their staffs and geographic footprints while technological changes have reduced the cost to service customers.

Large money center institutions (JPM), (C), (WFC), and (BAC) have been dealing with the aftermath of their acquisitions during the Global Financial Crisis (reducing waste, legal ramifications, increased regulatory scrutiny, etc.) and are generally limited to organic growth. While there may be some appetite for more acquisitions, in the near term they are limited to digesting their most recent takeovers. Indeed, it is unlikely that regulators would allow anything more than small bolt-on acquisitions. No transformational acquisitions here.

However, large regional banks – super-regionals or universal regional banks – are on the rise. While others use the term super-regional (which in many cases is apropos) I prefer the term universal regional banks to describe this growing trend in regional banks. Regional banks tend to have strong consumer presences, even more so super-regionals. However a universal regional bank aspires to function much like a universal bank with a strong consumer franchise, commercial franchise, and investment banking and securities franchise.

These banks maintain decent efficiency and those that survived the crisis were generally more conservative, better managed banks. As such, they were often able to grow organically or through acquisitions. Many have strong wealth management businesses and have bought or grown small investment banking practices.

A prime example of the transformation from a regional to universal regional to universal bank is that of Bank of America (BAC). Once a small regional bank in the Southeast, Bank of America grew by leaps and bounds, gobbling up wounded competitors at opportune moments (and sometimes inopportune moments). Perhaps the most notable actors in the bank consolidation drama of the 1980s-2000s are Sandy Weill and Jamie Dimon whose actions led to the creation of both Citigroup and what is now JPMorganChase (JPM). C and JPM will be discussed further in this series.

US Bank (USB) is generally seen as one of the best managed banks in the business (though they are also helped by their company’s product mix). Their return on equity and efficiency ratio are consistently among the best in class (most recently the return on average common equity was 14.5% and the efficiency ratio was 52.4%). However, given their recent integration of Charter One in the Midwest, USB is unlikely to make any large acquisitions in the near future. USB will be discussed further in this series.

Others, such as PNC (PNC) or SunTrust (STI) have strong franchises and advantageous footprints that have benefited from the recent recovery in the American economy. Both banks have strong commercial presences, good consumer brands, and even small investment banking businesses. Both of them are on the verge of being universal regional banks. Other examples of potential universal regional banks include M&T Bank (MTB) and BB&T. In fact, since the original writing of this article, BB&T has announced its intent to acquire Susquehanna Bancshares, a strong move into the upper mid-Atlantic market.  STI, PNC, and BBT will be discussed further in this series.

Some regional and aspiring universal regional banks have truly taken advantage of the crisis to grow or transform their businesses. Banks with the potential to become super-regionals and perhaps even universal regional banks include Bank of the Ozarks (OZRK) and BankUnited (BKU). These banks have transformed their businesses over the last 5 years. They have done an excellent job of leveraging their brands and they may have significant room for organic and inorganic growth in the future. BKU and OZRK will be discussed further in this series.

Suffice to say that with increased regulation, small regional banks and even large community banks face increased costs and may fall prey to growing universal regional banks that seek to rise in the food chain. As the need for a national brand grows in importance over the next decade, these universal regionals may feel forced to grow, lest they find themselves prey to organic declines or acquisition.

Investment Banks

Investment Banks on the other hand are dealing with a changed landscape after the Global Financial Crisis. Limitations on proprietary trading, regulatory requirements such as new minimum capital ratios, and new Fed oversight impact both the top and bottom line. Investment banking, perhaps even more so than commercial banking is built upon brand and trust.

M&A advisory only thrives if companies can trust their advisor. Prime brokers have trouble drumming up business if they cannot convince their institutional clients that they will be solvent the next Monday. Investment banking is in the trust business and the trust of many stakeholders was shaken during the Global Financial Crisis. As a result, there have been tectonic shifts in the business models of the major investment banks.

M&A advisory groups in bulge bracket investment banks, though still profitable, face increased competition from boutique advisory companies such as Moelis & Company (MC), Evercore (EVR), Centerview Partners, Greenhill & Co (GHL), and smaller traditional investment banks such as Lazard (LAZ) and NM Rothschild. With Paul Taubman’s success with a kiosk-style advisory business (and his imminent move to lead Blackstone’s (BX) soon to be spun-off advisory business) there are several competing business models challenging the bulge bracket one-stop shops. I may include an article or two about trends in the M&A boutique market in this series.

The industry seems to be realizing that there is only so much room in the ecosystem for apex predators. Most large investment banks are scaling back operations in one area or another to de-risk. Most are emphasizing lines of businesses where they have relative strengths. Goldman Sachs and Deutsche Bank are among the few to maintain an emphasis on trading (though in recent quarters Morgan Stanley has done well in FICC as well). Others are refocusing on asset-management and reducing their FICC and even M&A groups.

For example, Barclays has been shrinking its investment bank (the remnants of Lehman Brothers). UBS has done the same with its investment banking operations (the remnants of SG Warburg and several others) to capitalize on its leadership in the asset management space. Morgan Stanley’s completion of its acquisition of the SmithBarney franchise from Citi has strengthened its brokerage business and has reduced its overall risk. These are likely to be smart strategic moves for these businesses as they must both reduce risk and maintain profitability. 2007-2009 showed the investment banking world the danger of banks being all things to all people.

What has become clear is that there is plenty of room for niche players in the businesses that comprise investment banking. There is the possibility that we will see proliferation of firms and greater specialization of firms such as was seen in the 1950s and 1960s rather than the universalization of investment banking franchises as was seen in the 1970s and 1980s. There may be more firms starting in the mold of Donaldson, Lufkin & Jenrette ((DLJ)), Cogan, Berlind, Weill & Levitt ((CBWL)), and Keefe, Bruyette & Woods ((KBW)) over the next few years as the costs of doing business in a universal bank increases and sell-side research shrinks. Investment research is becoming privatized and brought in house for most institutional investors while also being democratized with small investment banks focusing on small caps and non-traditional outfits such as Zacks, the Street, an even Seeking Alpha provide individual (and occasionally institutional) investors a place to go for research.

There may be room for a few small firms to shine that provide high caliber research as did many of the smaller firms started in the post-war era.  I will likely include an article or two on the middle-market investment banking space as well as a number of the industry specific investment banks. As such the trends to be considered in the investment banking industry includes specialization among larger bulge-bracket investment banks and proliferation of smaller businesses focused in advisory, restructuring, trading, and research.

The aforementioned trends in commercial banking and these trends in investment banking seem to be on a fascinating collision course. As larger regional banks aspire to become universal regional banks (a transformation that was only fairly recently taken by both Wells Fargo and Bank of America) they will likely try to build or bolster their investment banking practices through selective hiring or the acquisition of small but reputable firms. Therefore, while the investment banking industry will likely become more fractured over the next 5-10 years, there will likely be consolidation in the commercial banking industry.  In fact, there may be several acquisitions of investment banking practices by aspiring universal regional banks.


Banking is built upon trust. J.P. Morgan said this over a century ago in a hearing before the Pujo Committee. When asked about what was most important when loaning money, he said character. When asked why trust mattered more than assets, Morgan said, “Because a man I do not trust could not get money from me on all the bonds in Christendom.” He continued, “I think that is the fundamental basis of business.”

The trust deficit in the financial industry and the growing importance of national brands in finance is going to be a driving force over the long duree of American finance. Throughout this series of articles, I will examine these trends in more depth and seek to elucidate upon their tangible effects on American business and finance.

Disclosure: I am long BX, LTS, UBS.