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.
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The latest deterrents, nagging macroeconomic issues -- the
European sovereign debt crisis in particular -- and regulatory
pressures, are continuously causing the sector's
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
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
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 of 2013.
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
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 environment.
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
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 continent.
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
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
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 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 regulatory investments.
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
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