Is a breakthrough imminent for the U.S. banking sector? Regulatory easing may become a key catalyst

In the past few years of the hot rally in the U.S. stock market, the banking sector has been in a "lagging" position. However, with the release of stress test results and the relaxation of bank capital rules, many analysts on Wall Street see an opportunity for the sector to break upward.

Data shows that the KBW Bank Index is still more than 7% lower than its historical high in 2022, while the S&P 500 Index has risen more than 30% during the same period.

Wells Fargo's star bank analyst Mike Mayo stated, "Bank stocks are facing a 'triple positive' situation." He believes that the banking industry is experiencing the largest regulatory turning point in thirty years, while operational leverage is improving and revenue continues to grow:

"As long as there is no economic recession, bank stocks will soar."

Mayo accurately predicted last year that bank stocks would undergo a revaluation and expects significant gains in the future. Although Trump's tariff plan briefly impacted the market in April this year, causing a temporary setback to his predictions, these concerns have begun to dissipate as the U.S. stock market benchmark index returns to near historical highs.

Investors will closely monitor the annual stress test results released by the Federal Reserve this week for signs of capital constraint relaxation. The results will be announced on Friday at 4:30 PM Eastern Time.

Easing Pressure, Relaxing Capital

Ian Katz, managing director at Capital Alpha Partners in Washington, expects all banks to pass the tests, which will provide room for the banking group to increase stock buybacks and dividend distributions. The Federal Reserve also plans to lower the restrictive measures for future tests. Katz wrote in a report:

"The market expects the 22 banks undergoing the tests to perform well, partly because the severity of this year's adverse scenario seems slightly lower than last year's."

In addition, comprehensive regulatory reforms are underway. The Federal Reserve announced a plan on Wednesday aimed at lowering the so-called "enhanced supplementary leverage ratio," which requires banks to hold a certain proportion of capital relative to their assets.

Federal Reserve Vice Chair for Supervision Michelle Bowman supports the plan to revise capital rules. Under Bowman's leadership, bank merger and acquisition activities are also expected to accelerate. After the Biden administration's strict scrutiny of transactions led many companies to adopt a wait-and-see attitude, she anticipates a more proactive approach to mergers and acquisitions.

Morgan Stanley analyst Betsy Graseck and her team noted in a recent report that under Bowman's leadership, "faster and more transparent merger approvals" will be achieved. "Regulatory clarity is the key unlocking factor for mergers and acquisitions."

Speculation about mergers and acquisitions in the market has heated up. On Monday, reports emerged that Bank of New York Mellon Corp. might make a large acquisition of Northern Trust Corp., which subsequently vowed to remain independent

Mixed Prospects: Opportunities and Challenges Coexist

Of course, the banking sector still faces the risk of not keeping up with the market's upward momentum. A report from Jefferies Financial Group Inc. this Wednesday provided early clues for the quarterly earnings report set to be released in July. The bank's investment banking and capital markets revenue has been affected by economic and geopolitical turmoil.

Additionally, the Federal Reserve's policy path remains far from clear. While banks typically benefit from high interest rates, the series of bank failures in March 2023, including Silicon Valley Bank, has warned that high rates could impact financial liabilities.

Cole Smead, CEO of Smead Capital Management, stated that the company is currently buying bank stocks, but its focus is highly concentrated on net interest margins. He said:

“The higher the nominal long-term interest rates, the greater the harm to trading and wealth management businesses.”

Smead believes that regional banks, which rely less on trading income, are under less pressure. Analysts at Baird also favor regional banks, as they believe that given the recent strength of large-cap stocks, the upside potential for large banks is limited.

HSBC analyst Saul Martinez stated:

“As long as it does not trigger an economic recession and/or credit issues, ‘higher for longer’ interest rates are beneficial for bank profitability.”