As the first months of the new administration unfold, one sector that seems poised to benefit from both lighter regulation that the Trump administration promises, as well as the Federal Reserve’s (Fed’s) path toward higher interest rates, is...regional banks...due to their simplified, lending-focused business models.

Written by Heidi Richardson (BlackRockBlog.com)

As the name suggests, regional banks are depository institutions that operate across groups of states but below the national level. These organizations could see potentially significant regulatory relief under the new administration if they are legally differentiated from larger, more complicated bulge bracket banks, which represent the country’s largest multinational investment banks.

For example, there are proposals to raise the $50 billion threshold for “Systemically Important Financial Institutions”, a Dodd-Frank designation for 33 banks whose failure could trigger a financial crisis. With many regional banks at present grouped alongside bulge brackets under the current minimum, increasing the threshold could grant regional banks more operational freedom than their larger peers.

Broadly speaking, regional banks earn revenue from lending and pay fees on deposits. When interest rates edge higher, the spread between income from loans and payments on deposits typically widens, which can help increase bank profitability through higher net interest margins. Although the low interest rate environment over the past decade has compressed bank NIMs, we expect U.S.-led reflation—rising nominal growth, wages and inflation—to accelerate. Refer to the chart below.

Markets could also be underpricing the possibility of more and larger rate hikes in 2017, given the Fed’s apparent increasing confidence in job and wage growth. This has paused further steepening in the U.S. Treasury curve, but yields could rise when the Fed signals more aggressively.

Due to their lending-focused business models, regional banks may be among the best-positioned financial firms to capitalize if, or when, Fed action causes interest rates to increase.

In addition, regional banks’ relatively simplified structure could also make them more resilient to capital market headwinds than larger banks. The largest U.S. banks have seen fluctuating trading revenue in recent quarters, particularly in fixed income, while regional banks have typically not engaged in such activities. Regional banks also tend to be more domestically-focused, meaning their bottom lines may be less impacted by a strong U.S. dollar, which could potentially erode non-dollar revenue earned abroad.

However, it is important to note valuations have increased significantly since the election, as investors anticipate an easing of financial regulations. This, of course, potentially sets the stage for disappointment (and a selloff) should that not occur.

Nonetheless, regional banks may stand to gain the most among financials from regulatory easing and a more favorable macroeconomic environment—assuming both occur. Larger banks may still perform strongly in a reflationary environment and may serve as a portfolio diversifier.

(Investors looking to access regional bank equities may want to consider iShares U.S. Regional Banks ETF (IAT). For broader financial services, consider iShares U.S. Financial Services ETF (IYG).)