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The Dilemma for Regional Banks

Varun is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Regional banks have emerged stronger after the financial crisis. However, most regional banks have been facing significant margin pressure as the Federal Reserve has kept interest rates at record low levels. While the low interest rate has helped in boosting lending activity, it has hurt banks’ margins. Although regional banks are hoping for a rise in interest rates, they face a dilemma. A sudden rise in interest rates could hurt lending activity.

Emergence from Financial Crisis

Regional banks were among the hardest hit by the subprime mortgage crisis and subsequent financial crisis. Since then, regional banks have been strengthening their balance sheet. Several regional banks have emerged significantly stronger after the crisis as evidenced by their balance sheet.

At the end of the first quarter of 2013, PNC Financial (NYSE: PNC) had reported a Tier 1 common capital ratio of 9.8%. The bank’s estimated pro-forma Basel III Tier 1 common capital ratio was 7.9% at the end of the first quarter of 2013.

Another major U.S. regional bank, U.S. Bancorp (NYSE: USB) had reported Tier 1 common ratio of 9.1% and a Tier 1 capital ratio of 11% at the end of the first quarter of 2013. The bank’s Tier 1 common ratio under the proposed rules for the Basel III standardized approach was around 8.2% at the end of the quarter.

Huntington Bancshares (NASDAQ: HBAN) had reported Tier 1 risk-based capital ratio at the end of the March quarter of 10.62%. The bank’s Tier 1 risk-based capital ratio at the end of the March quarter stood at 12.16%.

Net Interest Margin a Worry for Regional Banks

The data above highlights the fact that regional banks have made a strong recovery post the financial crisis and are ready to meet with stringent Basel III capital requirements. However, the worry for U.S. regional banks at the moment is net interest margins.

Banks’ net interest margins have come under pressure as the Federal Reserve has kept interest rates at record low levels for four years now. Last year, mortgage rates fell to record low levels due to the Fed’s ultra-loose monetary policy measures, which include an aggressive bond buying program apart from record low interest rates.

The margin pressure has hurt regional banks’ net interest income. In the first quarter of PNC Financial Services had reported net interest margin of 3.81%, down from 3.85% reported in the previous quarter. The bank’s net interest income fell by $35 million on a sequential basis.

U.S. Bancorp’s net interest margin for the first quarter of 2013 was 3.48%, down from 3.55% reported in the fourth quarter of 2012 and 3.60% reported in the first quarter of 2012.

Low Interest Rate Environment Boosts Lending Activity

While the Fed’s ultra-loose monetary policy measures are hurting banks’ margins, they have boosted lending activity, especially commercial and industrial segments. In the first quarter, PNC Financial Services reported a 1% sequential increase in total commercial lending. U.S. Bancorp, meanwhile, had reported a 14.3% on a year-over-year basis in average total commercial loans. The bank’s average total loans grew 5.8% on a year-over-year basis in the first quarter of 2013.

Although lending activity has been picking up, the positive impact is being offset by downward pressure on net interest margin. At the time of the release of first-quarter results in April, Huntington Bancshares had noted it expects net interest income to modestly grow over the course of 2013.

Rise in Rates will Help Margins But Hurt Lending Activity

Regional banks are hoping for a rise in interest rates to ease some of the margin pressure. However, banks face a dilemma. A rise in interest rates could have a negative impact on lending activity, especially given the fact that the recovery in lending activity is still in early stages.

Just to gauge the impact of rise in interest rates on lending activity, one needs to look at the latest mortgage applications data from the Mortgage Bankers Association (MBA).

For the week ended May 31, 2013, the MBA’s seasonally adjusted index of mortgage application activity fell 11.5%. The reason behind the sharp decline was a sudden and sharp rise in mortgage rates. Mortgage rates, which fell to record low levels last year thanks to Fed’s QE3, have risen above 4% for the first time in a year amid talks that the Fed might start winding up its bond buying program as the economic environment continues to improve. For the week ended May 31, rates on fixed 30-year mortgages rose 17 basis points to 4.07%, according to data from MBA. In the last four weeks, mortgage rates have climbed 48 basis points.

Such sudden spike in rates is likely to hurt lending activity. Therefore any gains that banks make on improvement in net interest margin will be offset by a slowdown in lending activity.

Cautious on Regional Banks

Regional banks have had an excellent run in 2013 so far, with most of them outperforming the S&P 500. Year-to-date, PNC has gained over 19.50%, U.S. Bancorp is up more than 9%, and Huntington has gained more than 17.50%. However, the strong performance may not continue given the dilemma regional banks face. I would recommend remaining on the sidelines.

The big banks may be rushing to renew their focus on traditional banking, but well-run regional banks like PNC Financial are already there. PNC saw its share of hardships during the financial meltdown, but its management team thinks the bank is now back on track and ready to deliver for investors. Does this mean it's time to buy PNC? To help you figure that out, one of The Motley Fool's top banking analysts has authored a brand-new premium research report, delving into everything investors need to know about PNC today. To claim your copy, simply click here now for instant access.

Varun Chandan Arora, MBA has no position in any stocks mentioned. The Motley Fool owns shares of Huntington Bancshares and PNC Financial Services. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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