The Fed's 'Zombie' Army Can Only Make It So Far

It's hard to pinpoint exactly how many 'zombies' lurk within the banking industry...

Back in 2022, PNC Financial Services (PNC) found 30 zombie banks. In 2023, FIC Advisors estimated that there were more than 265 zombie banks out there.

Regular readers are familiar with the concept of "walking dead" institutions. Like the name suggests, a zombie bank is a bank that isn't dead... but it can't be considered alive and well, either.

The lights are still on at their branches. But the banks aren't making any loans because they can't. They don't have the cash.

Over the past two days, we've taken a deep dive into the troubles facing the banking industry. We started with a look back at a similar crisis – and opportunity – in the 1980s.

Then, we covered the events that led to the recent shaky environment for banks. In short, the Federal Reserve was stringing a lot of banks along, letting them just barely avoid death... while not showing many signs of life.

Today, we're homing in on the rise of these zombies... and what could happen when a new wave of deregulation hits the banking industry.

We can get a better idea of the number of zombies – or the number of banks approaching zombie status – with some quick calculations...

Specifically, we're looking at the value of banks' loan books. Declining gross loans indicates that a bank is shrinking and struggling to operate.

According to our analysis, 65 banks with market caps of more than $50 million have seen their loan books decline in the past six quarters... or 20%. For context, only 12 banks had declining loan books in the prior six quarters.

And it isn't just small banks whose loan books are declining. Gross loans at big banks like Truist Financial (TFC) and U.S. Bancorp (USB) have declined in the past six quarters.

These are massive institutions with market shares greater than $50 billion. And even they're struggling since the Fed began raising interest rates back in 2022.

So banks are facing a lot of uncertainty today. That said, there are still winners to be found in the rubble.

The stage is being set for stable banks to succeed... along with the investors who buy in early.

Many banks suffered from whiplash on the Fed's interest-rate roller coaster. There have been a lot of highs and lows since 2020.

However, higher interest rates have had the desired effect. The economy has begun to normalize as the Fed intended.

That means it can walk back some of the aggressive measures that have hurt banks for the past few years.

The first sign of a favorable banking market came on September 10, when the Fed announced a new Basel III proposal. The proposal requires only a 9% reserve increase for "systemically important" banks and a 3% to 4% increase for regional banks.

That's far more modest than its original 19%-and-10% proposal, which we mentioned yesterday. It will give banks more flexibility in their operations.

The Fed came out with more good news just over a week later, when it lowered interest rates for the first time since 2020. And it followed this up with a second rate cut back in November... and a third in December.

Lower rates will increase the demand for loans, leading to more business for banks. All of this points to stabilization in the banking industry. However, we don't think the industry will just return to its pre-pandemic levels again.

That's because the incoming Trump presidency is set to bring in a period of deregulation...

It will get a lot easier for banks to write loans. It could also lead to a wave of bank consolidation that we haven't seen in recent years, due to antitrust regulations that deterred acquisitions. (More on this tomorrow.)

There are plenty of zombie banks on the market today that make perfect acquisition targets. They have plenty of deposits and branches, but just aren't working. A bigger bank could absorb them and put their deposits to better use.

Now, talk of less regulation in the banking industry may ring some alarm bells for investors...

After all, deregulation was what led to the financial crisis in 2008.

We'd like to believe that regulators have learned from past mistakes... and that they won't let it happen again. We're not that naive, though.

If deregulation gets too extreme, we could see another 2008...

But not for years. And a lot will have to change first.

We're in the early stages of deregulation right now. It's too soon to know if it will be done right or not. Any potential downturns are years away.

In the meantime, there's a huge opportunity to profit.

Banks haven't been a market darling in some time. But prior to the Great Recession, they were some of the best places to put your money.

During the last wave of deregulation between 1991 and June 2007, banks outperformed the rest of the market by a staggering 210%.

Deregulation did wonders for banks back then. We expect the trend to repeat.

Regards,

Joel Litman
January 9, 2025