In order to plan the path to future growth, banks all over the
world are seeking new strategies to lessen the regulatory burden.
Almost every bank has its focus on capital efficiency. And most
of the foreign banks are adopting reconstruction-by-asset-sale
strategies to strengthen their capital ratios.
Self-protective efforts are significantly helping these banks to
stay afloat, though at the cost of moderating top and bottom-line
growth. Moreover, the industry remains thwarted by non-stop
challenges that are keeping its performance muted.
The latest deterrents, nagging macroeconomic issues -- the
European sovereign debt crisis in particular -- and regulatory
pressures, are continuously taking a toll on the financials of
many banks, resulting in the sector's underperformance.
As growth remains the primary focus of central banks, interest
rates are not expected to increase at least in the next couple of
years as inflation is not a major concern for most of the
countries other than a few emerging economies. Thus, banks
operating in a low interest rate environment will not be able
boost revenue through interest income. On the other hand,
non-interest revenue sources will be limited by regulatory
Banks in emerging economies will, however, not face significant
challenges related to interest income due to a not-too-low
interest rate environment. Anti-inflationary measures of the
central banks of these economies are expected to keep interest
rates high. However, non-interest revenue challenges will
Complying with stringent regulation is not a major concern for
most of the banks, but it would be difficult to optimize business
investments in the way banks run their businesses. So banks will
need to reassess and restructure their operating models to be
successful, which will take considerable time.
The Recent Past and Near Future
Despite a number of high-profile scandals, many of the world's
largest banks were able to gain investors' confidence in 2012 as
reflected by their share price performance. Many foreign banks,
including giants like
HSBC Holdings plc
), ended the year with substantially higher share prices compared
to the beginning of the year. Also, the MSCI World Bank Index
increased more than 20% in 2012.
However, with respect to the financial health, less resilience
was seen during the year than was anticipated. Growing challenges
related to funding, still-high costs despite belt-tightening
through layoffs and limited access to revenue sources kept
bottom-line growth under pressure.
The upcoming quarters don't look any better, with several
negatives hampering the sector like asset-quality troubles, high
borrowing costs, steeper expenses and weak loan demand. But
thanks to worldwide regulatory reform, the sector has at least
entered a transformation phase with the restructuring efforts in
place. Needless to mention, an essence of growth has yet to be
On the Fundamental Side
Looking at the fundamentals, a rising risk-aversion tendency has
still kept client activity slowed, resulting in weak trading
volumes and subdued credit demand. Also, learning from past
experience, banks are now more cautious about lending money.
Consequently, lower business activities and anticipated subdued
profitability are making foreign banks less appealing to
investors. Valuation multiples of these banks will continue to
reflect the fundamental challenges at least through the first
half of 2013.
The growth potential of some non-U.S. banks could be restrained
by higher reserve requirements and outsized losses related to
capital markets. But strict lending limits as part of the
regulatory overhaul as well as greater transparency in
regulations could strengthen the fundamentals of many sector
participants. Eventually, these are expected to create a less
risky lane for the overall industry.
As inter-country investment walls have fallen, some large
non-U.S. banks are freely expanding beyond their domestic
boundaries through mergers and acquisitions to utilize regional
regulatory benefits. On the other hand, regulatory pressure to
focus more on the home market is forcing some global banking
giants to sell overseas assets. Accordingly, banks are trying
hard to restructure their operating models and address funding
While the sector saw a moderate recovery in 2010, the performance
in 2011 was among the poorest in its history. Then in 2012, the
industry came across a number of new difficulties. But a
risk-averse approach helped it perform better than 2011.
The primary headwind for global banks is regulatory pressure,
which ensued from taxpayers' money and government intervention
that banks have relied on in order to remain in business.
Regulatory reform is a key issue for banks over the last few
years. The impact of regulations has yet to be fully felt with
many rules still impending.
Moreover, government efforts to alleviate industry concerns have
significantly raised political debates over time. Politics will
continue to influence lending decisions as long as banks remain
financially dependent on governments. According to banking
regulators, if governments withdraw their support from banks
before giving them sufficient time to restore their financial
strength, the sector could collapse again. The need for bailouts
is still felt acutely by the European banks.
Adding to the concern is the tendency of regulators worldwide to
agree on common minimum standards to prevent the recurrence of a
global financial crisis and restore public confidence. The
introduction of Basel III standards is a case in point.
With these regulatory measures, the individual capital structure
of banks will remain under constant pressure. Also, the efforts
to develop new business models will become much more expensive
and difficult. However, the resulting slowdown at some big banks
could be seen as a blessing in disguise, as it would eventually
make their balance sheets more recession-proof and provide a new
set of opportunities.
Valuations Look Attractive
Balance sheet repair and credit environment recovery will make
the valuations of some non-U.S. banks attractive going forward.
Particularly, valuations of the mega banks, which could
comfortably maintain the minimum capital norms mandated by the
Basel Committee, will experience the fastest valuation upside.
Consequently, we believe this would be a good time for long-term
investors to consider foreign bank stocks, as the valuations at
present look comparatively cheaper.
Investors with short-term targets, however, should be watchful
while choosing foreign bank stocks at this point as near-term
fundamentals do not look promising. Asset quality lacks the
potential to a rebound anytime soon as default rates for
individuals and companies are not expected to materially subside,
and revenue growth might remain weak with faltering loan growth
and a low interest rate environment in most of the countries.
If any improvement occurs in the near-to-mid term, it will vary
from country to country, depending on industry circumstances.
Rating downgrades remained a major threat for major global banks
in 2012. Lingering macroeconomic issues and sovereign crises
across Europe dampened the credit profile of many banks to a
notable extent. This prompted the rating agencies to take
negative rating actions on these banks during the
In July 2012, Moody's Investors Service, the rating arm of
), downgraded credit ratings of 15 systematically important banks
in the U.S., U.K. and Europe. The downgrade was based on the
agency's concern related to these banks' significant exposure to
the volatility and expected losses from capital market
In October 2012, Standard and Poor's (S&P) downgraded three
French banks due to rock-bottom French consumer confidence.
However, Moody's, in its global banking outlook for 2013, stated
that the ratings of global banks are expected to be relatively
stable. The rating agency will keep an eye on excessive
risk-taking by banks to offset the negative effects of low
interest rates, elevated sovereign risk for the European banks
and impacts of regulatory reforms.
European banks are expected to underperform in the upcoming
quarters due to increasing capital pressure emanating from the
ongoing debt crisis in the region.
Though the funding situation in Europe has improved to some
extent backed by huge aids from the European Central Bank, there
remain deep concerns related to the banks' ability to meet
Italy and Spain showed signs of improvement with support from the
government and European Central Bank, but conditions in Greece
remain uncertain due to issues related to additional bailout
European policymakers have taken a number of important steps
including the purchase of government bonds by European Central
Bank. These actions have helped the European markets to stabilize
to some extent. However, the policymakers need to take additional
steps to alleviate investor panic and restore confidence.
Otherwise, the risk of a credit crunch will deepen further.
Overall, the European Union is trying hard to restore investor
confidence as well as fundamentally reshape the continent's
banking system. The issue, however, remains far from being
Coming to the banks in emerging economies, the asset quality
trouble is obvious. However, these are not plagued by other
serious problems that many of the larger banks face in
continental Europe and the United Kingdom, such as toxic
securities and dilution from capital raising. Moreover, these
emerging-market banks generally tend to be well capitalized,
aren't as heavily exposed to property markets, and have
significant and growing sources of non-interest income.
We believe that banks in emerging economies -- Chile, Brazil and
India -- look more attractive, akin to certain regional banks in
the U.S., Australia and Canada that have capital strength, good
funding and growth potential.
Overall, a key determinant for a quick recovery will be the
quality of risk analysis and risk awareness in decision making
and incentive policies. So, we believe that accumulating larger
capital buffers over the cycle and reducing pointless complexity
in business will be crucial to banking performances.
Also, only cost reduction by job cuts and asset sales is no
longer considered enough. Instead, the aim should be to enhance
operational efficiency through fundamental changes in business
models. The capital goal of global banks should be more than just
complying with regulatory requirements. Banks need to reshape
their operating models to convert regulatory mandates to
On the other hand, the primary attention of policymakers should
be on determining the span of fiscal stimulus, ensuring that it
remains till a clear sign of transition from recovery to growth
Among the non-U.S. banks, we recommend
Banco Bilbao Vizcaya Argentaria S.A.
BBVA Banco Franc
Bank of Communications Co. Ltd.
China Merchants Bank Co. Ltd.
Shinhan Financial Group Company Ltd
) that have a Zacks Rank #1 (Strong Buy).
We also like banks with a Zacks Rank #2 (Buy) including
Bank of Montreal
Credit Suisse Group
ICICI Bank Ltd.
KB Financial Group Inc.
We would suggest avoiding European banks at this point, including
banks in Great Britain and Ireland. The weaker banks are those
that have participated in government recapitalization programs
and are yet to repay. In return of government capital and asset
quality protection, these banks are facing regulatory
intervention, like enforcing limits on dividend payouts and board
Currently, the only bank we dislike with a Zacks Rank #5 (Strong
Erste Group Bank AG
We also dislike some stocks in the non-U.S. bank universe with
the Zacks Rank #4 (Sell), namely
Banco Santander, S.A.
Canadian Imperial Bank of Commerce
HDFC Bank Ltd.
Mitsubishi UFJ Financial Group Inc.
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