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A blistering rally in the shares of regional banks may be tested when a spate of lenders report results in the coming week.

Regional banks in the S&P 500 have surged 11 per cent since the beginning of the year, beating out the gains in larger, more diversified banks by about a percentage point over the same period. Both regional and diversified banks are running well ahead of the benchmark S&P 500, buoyed by a rise in Treasury yields to their highest levels since the pandemic began on expectations that additional fiscal stimulus will spur economic growth.

Smaller banks often outperform during the early stages of an economic recovery because their earnings and revenues are more reliant on the products affected by higher Treasury yields than their larger competitors, which more often have additional revenue streams such as trading or capital markets divisions.

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Coming earnings reports will show if that trend holds this time around. Much of the pain from COVID-19-fuelled lockdowns has fallen on the smaller businesses and low-to-middle income consumers that are more likely to be customers of regional banks, said Ian Lapey, portfolio manager of the Gabelli Global Financial Services Fund.

“The large banks with the large customers are in better shape across the board” because of their greater access to credit markets and investment banking income, he said. This year “is going to be a challenging year for regional banks. Interest rates have moved up but they’re still very low and unemployment is still high and won’t recover quickly even with the vaccine.”

As a result, Mr. Lapey is only holding regional banks with “pristine credit quality” such as Webster Financial Corp. and First Citizens Bancshares Inc., both of which are up more than 10 per cent since the start of the year.

Regional banks, including Zions Bancorp., First Midwest Bancorp Inc. and United Community Banks Inc., are expected to report their quarterly results on Tuesday.

Over all, larger banks will grow earnings by an average of 112 per cent in the coming year while regional banks will grow their earnings by an average of 33 per cent, said Dick Manuel, an equity research analyst at Columbia Threadneedle Investments.

That trend will continue into the following year as well, with larger banks posting an average 29-per-cent earnings growth between 2021 and 2022 while regional banks post average earnings growth of 13 per cent, he said.

At the same time, larger banks are trading at 11.5 times their anticipated 2022 earnings on average, compared with an average 13.3 times 2022 earnings multiple among the largest regional banks, Mr. Manuel said.

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David Ellison, a portfolio manager who runs two financial funds at Hennessy Funds, sees little value in regional banks at a time when online lenders such as SoFi, PayPal and Square are poised to eat into their customer base for personal and small business loans.

“The reality is that these franchises are losing value at a faster rate because technology platforms are out there making loans electronically,” he said. “Kids are entering the banking system today through Robinhood or Venmo or SoFi, they’re not going down to the regional bank in their town.”

As a result, he is focusing his exposure on regional banks that are either poised to take over their competitors or be acquired by a rival.

“The opportunity in the space is not an earnings recovery because they never really went down,” he said. “The opportunity is consolidation.”

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