Higher interest rates promise stronger net interest income for the banking industry, but bank stocks are trading at discounted prices because investors are concerned about potential threats to bank liquidity and credit quality, according to KBW CEO Tom Michaud.

In the latest "Street Talk" podcast recorded Oct. 5 — marking the show's 100th episode — Michaud discussed current bank stock valuations, the impact of higher rates on deposits, liquidity and credit quality, and how those factors are affecting M&A activity.

Bank stocks have come under pressure in 2022, even as the return of higher interest rates has promised expansion in net interest margins and higher earnings for many institutions.

Michaud said the banking industry is operating in two worlds: the world of what is happening right now and the world that investors are really worried about. He said KBW, a unit of Stifel Financial Corp., believes the industry could post nearly 20% net interest income growth in the coming quarter due to higher interest rates and stronger loan growth, leading to positive operating leverage. But, Michaud said the Street is nervous about earnings over the next few years as investors are fearful that higher credit costs and liquidity constraints could lie ahead.

"Normally, increasing earnings estimates make stocks go up. That hasn't happened because the P/E ratio has dropped considerably because investors don't believe the earnings. And they believe there's too much macro uncertainty in the economy," Michaud said. "Investors would rather buy the stocks 10% higher with more certainty than buy them now with as much uncertainty."

Part of the uncertainty relates to liquidity on bank balance sheets. Michaud said monetary and fiscal policy created $3 trillion in excess deposits — funds he expects to leave the banking industry. He said some banks let their deposits decline in the second quarter because they have been happy to let higher-cost funds go.

The executive noted that deposit betas, or the percentage of change in the federal funds rate that banks passed through to depositors, have remained below the last rate hike cycle thus far, but said KBW expects betas to eventually be roughly in line with the prior cycle, suggesting that they will begin heating up soon.

"It's going to be different this time because I don't think we've ever done this before so investors are nervous about that and how that's going to play out," Michaud said.

The Street is also focused on the potential for notably higher loan losses to come in the future. The executive noted that banks used much of the historic deposit growth during the pandemic to grow their securities portfolios considerably. As rates have moved higher, those portfolios have moved underwater, weighing on tangible book value.

Rates continued to increase in the third quarter and Michaud expects that development to once again weigh on tangible book values in the period. Still, he noted that banks' securities portfolios likely do not present much credit risk to institutions.

He also noted that regulations passed in the aftermath of the Great Recession have led to stronger underwriting in banks' loan portfolios. He said a lot of risk actually moved out of banks and into the shadow banking industry, which ballooned amid the low-rate environment. For instance, he noted that the size of Apollo's credit funds in aggregate would create the 10th-largest bank in the country.

"There are some real players out there that aren't banks in the marketplace so some of the risk has moved away," Michaud said. "I think the investors are just nervous. And while they think the banking industry could do fine, I think they want to see them prove it a little bit. It's a little bit of a show-me situation with the stocks."

Investors are also waiting for inflation to break and for the Fed to stop tightening monetary policy. He noted that the futures market suggests that the central bank is getting closer to a terminal rate for the benchmark fed funds rate. Once investors see a green light in the economy, Michaud believes bank stocks could move materially higher.

"At some point, investors in bank stocks will feel like the banks are getting a passing grade. And when that happens, it will be an incredible rally," Michaud said.

"Street Talk" is a podcast hosted by S&P Global Market Intelligence.

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