Just as banks worldwide are focusing more on capital efficiency,
most foreign banks have been adopting reconstruction-by-asset-sale
strategies to strengthen their capital ratios and lower leverage.
Self-protective efforts have been significantly helping these banks
to stay afloat, but 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 causing 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 markets. Thus, banks operating under 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 restrictions.
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 central banks of
these economies are expected to keep interest rates high. However,
non-interest revenue challenges will persist.
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 business. 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
The sector showed less resilience in the first nine months of 2012
than 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
plaguing 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, a change has yet to be felt.
On the Fundamental Side
Looking at the fundamentals, a rising risk-aversion tendency has
been gradually reducing client activity, resulting in lower 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 attractive to
investors. Valuation multiples of these banks will continue to
reflect the fundamental challenges at least through the first half
Though the growth potential of some non-U.S. banks could be
restrained by higher reserve requirements and outsized losses
related to capital markets, strict lending limits as part of the
regulatory overhaul as well as greater transparency in regulations
could strengthen the fundamentals of many banks. 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 exploit 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 needs.
While the sector saw a moderate recovery in 2010, the performance
in 2011 was among the poorest in its history. Also, the industry
has come across a number of difficulties so far in 2012. However,
these obstacles notwithstanding, there is no gainsaying that the
global financial crisis is finally behind us.
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. 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.
The industry has been adopting tougher regulatory measures to
prevent the recurrence of a global financial crisis and restore
public confidence. The introduction of Basel III standards is an
example of such measures.
With these regulatory measures, the individual capital structures
of banks will remain under constant pressure. The resulting
slowdown at some big banks could be seen as a blessing in disguise,
as it would eventually make their balance sheets more
Valuations Look Attractive
Balance sheet repair and credit environment recovery will make the
valuations of some non-U.S. banks attractive. 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
Investors with short-term targets, however, should be watchful
while choosing foreign bank stocks at this point as near-term
fundamentals remain weak. Asset quality lacks the potential to
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
If any improvement occurs in the near to mid term, it will vary
from country to country, depending on industry circumstances.
Ratings downgrades are a major threat for major global banks. In
July 2012, Moody's Investors Service downgraded credit ratings of
15 systematically important banks in the U.S., U.K. and Europe. The
foreign banks include the likes of
Credit Suisse Group
HSBC Holdings plc
Deutsche Bank AG
The downgrade was based on the agency's concern related to these
banks' significant exposure to the volatility and expected losses
from capital market activities. This rating action could compel
many of these banks to post billions in additional collateral,
which will make derivative trading costly. Also, already-high
borrowing costs for these banks will increase further.
In October 2012, Standard and Poor's (S&P) downgraded three
French banks, including BNP Paribas, due to rock bottom French
consumer confidence. Also, in a report issued in the same month,
Moody's kept a negative outlook on Germany's banking system as it
believes intense competition, margin pressure due to a low interest
rate environment, high balance-sheet leverage and low pre-provision
profits will make it difficult for a number of German banks to stay
afloat if they incur major losses.
Further, in October 2012, Moody's placed the long-term ratings of
Canadian banks - Bank of Montreal
The Bank of Nova Scotia
), Caisse Centrale Desjardins,
Canadian Imperial Bank of Commerce
National Bank of Canada
The Toronto-Dominion Bank
) - on review for a possible downgrade. According to the ratings
agency, these banks are more susceptible to an economic slump than
ever before due to high consumer debt and soaring housing prices.
European banks are expected to underperform in the upcoming
quarters due to increasing capital pressure emanating from the
ongoing debt crisis in the region.
In early 2010, the debt crisis originating in the Greek economy
shook the stability of the European Union's (EU) monetary policies.
Starting as a solvency crisis in a single country, the turmoil
spread over to the entire Eurozone.
The situation did not stabilize to a great extent in 2011, despite
financial assurance from EU leaders. In 2012, the European debt
crisis heightened, spreading fears of a financial collapse in the
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 capital
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 funds.
According to the IMF, 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 in recent months. 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 not just to restore
investor confidence but also the health of the continent's banking
system. The issue, however, remains far from being addressed.
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
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 focus should be on increasing
operational efficiency through fundamental changes in business
models. The capital goal of global banks should be more than just
complying with regulatory requirements and increasing returns from
The primary attention of policymakers should be on determining how
much longer fiscal stimulus should continue, ensuring that it is
not withdrawn before a clearer sign of economic recovery is
Among the non-U.S. banks, we recommend
Royal Bank of Canada
HDFC Bank Ltd.
China Construction Bank Corporation
Bank of Communications Co., Ltd.
) that have a Zacks #1 Rank (short-term Strong Buy rating).
We also like banks with a Zacks #2 Rank (short-term Buy rating)
Banco Santander, S.A.
The Bank of Nova Scotia
Canadian Imperial Bank of Commerce, KB Financial Group,
Shinhan Financial Group Company Limited
The Toronto-Dominion Bank
Mizuho 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 have
yet to repay. In return for government capital and asset quality
protection, these banks are facing regulatory intervention, like
enforcing limits on dividend payouts and board member nominations.
Currently, banks that we dislike bearing a Zacks #5 Rank
(short-term Strong Sell rating) include
Itau Unibanco Holding S.A.
Banco do Brasil S.A.
Agricultural Bank of China Limited
We also dislike some stocks in the non-U.S. bank universe with the
Zacks #4 Rank (Sell), namely
Lloyds Banking Group plc
National Australia Bank Limited
Banco Latinoamericano de Comercio Exterior, S.A
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