Strong earnings growth will continue for banks in 2026, says KBW's Christopher McGratty

Key Concepts

• Yield Curve: The difference in interest rates between long-term and short-term bonds. A steep yield curve is generally seen as a positive sign for bank profitability.
• Net Interest Income (NII): The difference between the revenue a bank generates from its lending activities and the expenses it pays out to depositors.
• Tangible Book Value (TBV): A measure of a bank’s net asset value, excluding goodwill and other intangible assets.
• Return on Equity (ROE): A measure of a bank’s profitability relative to shareholder equity.
• Credit Spreads: The difference in yield between corporate bonds and government bonds, indicating the perceived risk of lending to corporations.
• Capital Markets: Venues where savings and investments are channeled between suppliers of capital and those who need it.
• M&A (Mergers & Acquisitions): The consolidation of companies or assets through various types of financial transactions.

Financial Sector Outlook for 2026: A Discussion with Chris McGrady of KBW

Introduction & Macro Backdrop

The financial sector has been the top-performing sector in the current month, and the discussion centers on whether this positive trend will continue into 2026. Chris McGrady, Head of U.S. Bank Research at KBW, attributes the strength in 2025 to healthy capital markets, specifically noting tight credit spreads. However, he emphasizes the importance of monitoring credit spreads going into 2026. A key factor supporting bank performance is strong, double-digit earnings growth, which is expected to persist.

Drivers of Bank Performance: Large vs. Small Banks

McGrady highlights a significant performance disparity between large and small banks. Large banks have seen an average year-to-date increase of 40%, while smaller banks have risen approximately 15%, creating a 20-25% spread. The primary driver of performance in 2025 has been capital markets activity – M&A trading and investment banking – with volumes up 40%. For this positive trend to broaden in 2026, three conditions are crucial: a steep yield curve, a return of loan growth, and benign credit conditions, all of which were prevalent in 2025.

The Role of the Federal Reserve

The Federal Reserve’s monetary policy plays a critical role in the health of banks. While McGrady indicates KBW aligns with expectations of one potential rate cut in 2026 (though 1 or 2 cuts wouldn’t dramatically alter earnings), maintaining a steep yield curve is paramount. He explains that the longest period of yield curve inversion has ended, leading to a repricing of bank balance sheets. This “back book dynamic” will support net interest income, even with lower funding costs, creating a favorable revenue growth environment. As McGrady states, “Regardless if the Fed goes once or twice, there’s a back book dynamic that’s really going to support net interest income.”

Top Picks for 2026: Institutional Recommendations

McGrady recommends focusing on larger banks due to their scale across various business lines – deposits, capital markets, and technology spending – resulting in higher and more stable returns. However, he also sees opportunities in traditional banks. Specifically, he highlights KeyCorp and Citizens Financial, noting their ability to increase Return on Equity (ROE) from low double digits to mid-to-upper teens, while trading at a price-to-earnings ratio of ten. He attributes this positive outlook to the back book repricing, which provides revenue visibility regardless of Fed policy. Among large-cap banks, Citigroup (Citi) is identified as a top pick, trading at 1.2 times tangible book value and heavily leveraged to capital markets. Citi has a significant capital investor day planned for May, which is expected to further support its growth potential.

Closing the Performance Gap: Small vs. Large Banks

Investors have questioned why they should pay a premium (15x earnings) for larger banks when smaller banks are available at a lower multiple (10x earnings). McGrady suggests owning both, emphasizing that the larger banks are growing earnings at a rate that justifies their higher valuation. He believes this dynamic will continue, allowing both segments to perform well. “You know the banks at 14 15 times earnings. They’re growing earnings at 15 times. So we think that will continue to work.”

Data & Statistics Mentioned

• Large Banks YTD Increase: 40%
• Small Banks YTD Increase: 15%
• Capital Markets Volume Increase: 40%
• KeyCorp & Citizens Financial ROE Improvement: Low double digits to mid-to-upper teens
• KeyCorp & Citizens Financial P/E Ratio: 10x
• Citigroup TBV Ratio: 1.2x Tangible Book Value

Conclusion

The outlook for the financial sector in 2026 remains positive, driven by strong earnings growth, a potentially stabilizing yield curve, and favorable macroeconomic conditions. While large banks are currently favored due to their scale and stability, opportunities exist in select traditional banks like KeyCorp and Citizens Financial. The Federal Reserve’s policy will be a key factor to watch, but the “back book dynamic” provides a degree of resilience regardless of the number of rate cuts. Investors are advised to consider a diversified approach, owning both large and small banks to capitalize on the varying growth opportunities within the sector.