By Niket Nishant and Manya Saini

(Reuters) -U.S. regional banks’ profits outdid Wall Street expectations in the third quarter as their investment banking fees surged from a revival in dealmaking and helped offset higher deposit costs. 

Underwriting and M&A activity picked up pace, taking advantage of a stock market rally and leaning on a combination of economic resilience and hopes of more cuts in interest rates this year by the Federal Reserve.

“We are at a spot where all the probabilities favor increased dealmaking,” said David Russell, global head of market strategy at TradeStation. 

“(As) rates work their way lower in the next six to twelve months, there’s a strong possibility that we’re going to see more dealmaking.” 

The results underlined the growing relevance of investment banking to regional players. 

While such services have been largely a domain of Wall Street titans such as JPMorgan Chase, Goldman Sachs and Morgan Stanley, regional banks have carved a niche among middle-market firms.

“Better credit spreads and lower rates are helping fixed-income issuance and strong equity valuations should aid initial public offerings,” said Stephen Biggar, a financial services analyst at Argus Research, adding that improving CEO confidence is also helping mergers and acquisitions.  

Gains in investment banking helped the regional lenders soften the blow from higher deposit costs stemming from paying more interest to prevent customers from shifting to alternatives like money market funds.

Such pressures may ease as the Fed cuts rates further, Biggar said.

Huntington Bancshares, Truist Financial, KeyCorp and M&T Bank reported better-than-expected third-quarter profit on Thursday.

“This momentum could continue past the election and into year end,” said Michael Ashley Schulman, chief investment officer at Running Point Capital. 

“An uptick in M&As along with any sustained reopening of the IPO market should further fees and prop earnings.”

NORMALIZATION, NOT DETERIORATION

Banks are allocating larger reserves for potential loan defaults as consumers exhaust their savings built up during the pandemic, but executives say the increase is not a cause for alarm.

“The increases in provisions for loan losses the industry is seeing are largely driven by normalization rather than widespread credit deterioration,” said John Buran, CEO of Flushing Financial.

Still, regional banks may need to prudently manage their loan books, especially as they are heavily exposed to the troubled commercial real estate (CRE) sector.

“There is generally a higher amount of concentration to some more challenged CRE (among smaller banks) and the fundamental improvement will be dependent on a better environment for managing these loans,” said Macrae Sykes, portfolio manager at Gabelli Funds.

(Reporting by Niket Nishant and Manya Saini in Bengaluru; Additional reporting by Pritam Biswas and Arasu Kannagi Basil; Editing by Arun Koyyur and Alan Barona)

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