By Telis Demos

Things are shaping up for regional banks.

Shares of smaller lenders have had a poor run against their bigger peers in recent years. The KBW Nasdaq Bank Index, which tracks 24 of the largest U.S. lenders, is up almost 20% so far this year. The KBW Nasdaq Regional Banking Index, which tracks 50 smaller lenders, is up only 1%. The performance gap was over 20 percentage points in 2024.

Some of the biggest global megabanks are powering the larger-bank index. Shares of JPMorgan Chase, whose nearly $870 billion market value is more than twice that of the next bank, are up over 30% in 2025. Citigroup and Goldman Sachs are both up around 40%.

Yes, those banks have seen record activity in their trading businesses as clients scramble to keep up with fast-moving markets. But the real backdrop to this performance gap has been high interest rates.

Midsize banks can be more vulnerable to rising deposit costs, as they often are less reliant on vast stores of day-to-day checking accounts, and instead may rely on deposits from businesses, or attract consumers with higher-rate products such as certificates of deposit. Those customers are much more likely to seek out higher rates.

Many regional lenders' businesses also tilt less toward loans like credit cards or lines of credit to big companies, which have floating interest rates that rise as rates do. Instead, they are often more geared toward fixed-rate lending, particularly commercial property mortgages. So when interest rates rise quickly, their interest income is slower to ratchet higher. Fixed-rate loans also drop in value.

Now, however, the tide is turning on interest rates. After an extended pause, the Federal Reserve finally resumed its cuts in September. The market expects further cuts at future meetings. And a new Fed Chair will be appointed next year who may hew closer to President Trump's preference for low rates.

Importantly, too, many Wall Street strategists also expect longer-term rates to fall much slower or even rise relative to shorter-term rates -- for reasons ranging from inflation expectations to concerns about U.S. fiscal policy and Fed independence from the president.

Together, these forces seem likely to drive a steeper yield curve, with lower short-term rates but steady or even higher long-term rates.

And that is a shape that portends well for regional lenders. With falling shorter-term rates, regional banks that had to increase their deposit rates can lower them. Larger banks, which already have super low deposit costs, won't see as much benefit. And fixed-rate loans that were a drag when rates were rising become an advantage as they fall.

Analysts at Morgan Stanley estimated in a note this week that several of the regional banks they cover would see a boost to net interest income from five Fed rate cuts, including Ally Financial, Fifth Third, Huntington, Truist Financial and Valley National.

For many regional banks, one key ratio to watch is the difference between the yield on 5-year Treasury notes and the overnight rate set by the Fed's targets. Those are proxies for deposit costs on the liability side, and loans like commercial property mortgages on the asset side.

That gap is negative for now, meaning overnight rates are still higher than five-year yields, although it has been getting increasingly less negative in recent weeks. If the Fed keeps cutting as anticipated, it could turn positive again.

The broader economic picture may favor regional lenders, too. Investors are seeing trouble spots emerge in lending to consumers and to other financial institutions. Both are dominated by big banks, via credit cards and relationships with alternative-asset managers.

Meanwhile, things are finally starting to look up for pockets of business lending where regionals are strong. In commercial property lending in particular, more borrowers may finally be ready to refinance. However, any lower loan pricing would need to be offset with a big boost to volumes, or by borrowers leaving cash with the bank at a superlow rate.

Memories of what could happen if rates were to surprisingly reverse course and rise are also still fresh from the 2023 crisis marked by regional bank failures.

But relatively smaller banks are already pricing in a lot of risk. Before the Fed began raising rates in early 2022, regional banks as a group often traded at a premium valuation to larger peers overall. Regional banks in the S&P 1500 traded around 14 times forward earnings early that year.

Nowadays, they are far cheaper. JPMorgan trades at about 15 times forward earnings, and S&P 500 banks overall trade at 13 times. S&P 1500 regional banks trade at just 11 times.

There aren't many things that are arguably cheap in today's market. A solid earnings season could be enough to attract investors back to regionals.

Write to Telis Demos at Telis.Demos@wsj.com

(END) Dow Jones Newswires

October 01, 2025 05:30 ET (09:30 GMT)

Copyright (c) 2025 Dow Jones & Company, Inc.