Small US banks' shares ahead of larger rivals

Shares in the biggest US banks are lagging behind their smaller counterparts so far this year as investors await the start of tighter policy from the Federal Reserve.

Financial stocks have been laggards since January, trailing behind the broad market's rise of some 2 per cent, as expectations for rising rates have cooled in the wake of lacklustre US economic data. Higher interest rates are beneficial for banks because it means they can earn more from their portfolio of loans.

Bank and thrift stocks with a market capitalisation above $50bn fell 1.77 per cent in the first four months of the year, according to SNL Financial.

That compares with the SNL US Bank and Thrift index at a negative 0.52 per cent and a 7.19 per cent jump for banks and thrifts with a market cap of between $5bn and $10bn. Investors earned a total return of just under 3 per cent in the S&P 500.

During the period, the acquisition of City National Corp by Royal Bank of Canada helped to drive the smaller bank category with a nearly 16 per cent return for City National. The deal also created merger and acquisition speculation around other banks of similar size, adding to returns in the area.

"In the small bank world, there is much more rapid loan growth and they have more flexibility with capital," said Fred Cannon, director of research at KBW. "They are paying more dividends, buying back more shares and doing M&A."

After the share prices for larger banks outperformed in late 2014, their performance has ebbed as the bond market has largely priced out the prospect of the Fed increasing overnight borrowing costs from near zero per cent this year.

"Coming into the year everybody was cranked up for short-term rates to go higher," said Gerard Cassidy, head of bank equity research at RBC. He added, larger institutions benefit the most from increases in short-term rates because they have more business loans, which are typically tied to the London Interbank Offered Rate.

In contrast, Mr Cassidy said smaller, more regional banks with large commercial real estate portfolios are more dependent on the five-year Treasury yield.

The divergence between small and large bank stocks also reflects how since the financial crisis, large financial institutions, several with both commercial and capital markets businesses, have faced heightened regulations and large costs for legal troubles.

This week some of the world's biggest banks, including JPMorgan and Citigroup, are finalising agreements to collectively pay more than $6bn for allegedly manipulating foreign exchange markets.

"If you look overall since the financial crisis, you have continued regulatory pressure on big banks," said Mr Cannon.

In the past few months, however, large banks got a boost from their capital markets businesses, which were helped by rising volatility and volumes in the market.

"In the next six months, if the Fed funds rates is 25 to 30 basis points and volatility and higher volumes continue, big banks could outperform the regional and community banks," Mr Cassidy said.

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