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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 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 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.

Primary Headwinds

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 recession-proof.

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 comparatively cheaper.

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 Concerns

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 Barclays plc ( BCS ), Credit Suisse Group ( CS ), HSBC Holdings plc ( HBC ), Deutsche Bank AG ( DB ) and UBS AG ( UBS ).

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 six Canadian banks - Bank of Montreal ( BMO ), The Bank of Nova Scotia ( BNS ), Caisse Centrale Desjardins, Canadian Imperial Bank of Commerce ( CM ), National Bank of Canada ( NTIOF ) and The Toronto-Dominion Bank ( TD ) - 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.

Eurozone Woes

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 capital requirements.

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.

Emerging Markets

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.

Conclusion

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 visible.

OPPORTUNITIES

Among the non-U.S. banks, we recommend Royal Bank of Canada ( RY ), HDFC Bank Ltd. ( HDB ), China Construction Bank Corporation ( CICHY ) and Bank of Communications Co., Ltd. ( BCMXY ) that have a Zacks #1 Rank (short-term Strong Buy rating).

We also like banks with a Zacks #2 Rank (short-term Buy rating) including Banco Santander, S.A. ( SAN ), The Bank of Nova Scotia ( BNS ), Canadian Imperial Bank of Commerce, KB Financial Group, Inc. ( KB ), Shinhan Financial Group Company Limited ( SHG ), The Toronto-Dominion Bank ( TD ) and Mizuho Financial Group, Inc. ( MFG ).  

WEAKNESSES

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. ( ITUB ), Banco do Brasil S.A. ( BDORY ) and Agricultural Bank of China Limited ( ACGBY ).

We also dislike some stocks in the non-U.S. bank universe with the Zacks #4 Rank (Sell), namely Lloyds Banking Group plc ( LYG ), National Australia Bank Limited ( NABZY ), Bancolombia S.A. ( CIB ) and Banco Latinoamericano de Comercio Exterior, S.A ( BLX ).

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