U.S. banks showed some resilience in the recently reported
second-quarter results after a gloomy start to the year in a tough
industry backdrop. Weakness in capital market business and sluggish
mortgage banking activities prevailed but cost containment and
modest improvement in core businesses paired up to counter the
pressure. This still wasn't enough to report numbers better than
the year-ago quarter but thanks to conservative estimates, banks
delivered positive earnings surprises.
Looking at core businesses, though mortgage portfolios continued to
decline and pressure on net interest margin prevailed, the quarter
witnessed decent loan growth on the back of improvement in
commercial, industrial and auto categories. Also, the heightened
M&A and IPO activities led to solid investment banking
Legal costs, which have now become part of bank financials, did not
calm down during the quarter. In fact, these still remained acute
in the Q2 financials of a few banks. Notably, Bank of America
Corporation (BAC) revealed huge litigation expenses in its latest
report. With increasing regulatory scrutiny on the business model,
banks are not expected to get rid of such expenses at least in the
Overall, U.S. banks are having a rough time. Along with softness in
some business segments, too many mandatory defensive measures are
thwarting growth. With a dearth of significant loan growth
(primarily in the mortgage segment) and pressure on net interest
margins from a nagging low rate environment, top-line growth
However, banks have been trending toward higher fees to dodge top
line pressure. Easing lending standards to some extent after
complying with regulatory guidelines has also become a trend. Along
with these efforts, continued expense control and balance sheet
restoration should act as tailwinds in the upcoming quarters.
Further, a favorable equity and asset market backdrop, and
supportive macroeconomic factors - such as falling unemployment, a
progressive housing sector and flexible monetary policy - should
pave way for stability.
Interest rate spreads are unlikely to support top line soon as the
Fed intends to keep interest rates low for a considerable
time. On the other hand, along with continued decline in
revenues from mortgage fees, softness in the trading side of the
business should keep a lid on top line.
We don't see this issue-ridden sector returning to its
pre-recession peak anytime soon. What encourages us though is that
the U.S. banks are getting accustomed to increased legal and
regulatory pressure and resorting to safer alternatives for higher
returns. But structural changes in the sector will continue to
impair business expansion and investor confidence for some time.
Zacks Industry Rank
Within the Zacks Industry classification, U.S. banks are broadly
grouped in the Finance sector (one of 16 Zacks sectors) and are
further sub-divided into six industries at the expanded level:
Banks-Major Regional, Banks-Midwest, Banks-West, Banks-Northeast,
Banks-Southeast and Banks-Southwest. The level of sensitivity and
exposure to different stages of the economic cycle vary for each
We rank all the 260-plus industries in the 16 Zacks sectors based
on the earnings outlook and fundamental strength of the constituent
companies in each industry. (To learn more visit:
About Zacks Industry Rank
As a guideline, the outlook for industries with Zacks Industry Rank
of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral'
and #177 and higher is 'Negative.'
The Zacks Industry Rank for Banks-Southwest is #30, Banks-West is
#37, Banks-Midwest is #87, Banks-Northeast is #94, Banks-Southeast
is #104 and Banks-Major Regional is #105. Considering the Zacks
Industry Rank of the six banking industries, one could safely say
that the outlook for the group is 'Neutral' to 'Positive.'
Earnings Trend of the Broad Sector
All companies in the 'Banks-Major' and 'Banks & Thrifts'
industries, which are the medium-level (or M-level) components of
the broader Finance sector, have reported Q2 results. For
'Banks-Major', the earnings beat ratio (percentage of companies
coming out with positive surprises) was 86.7%, while the revenue
beat ratio was 93.3%. The picture for 'Banks & Thrifts' however
wasn't that strong - earnings and revenue beat ratios were 80% and
So far, 83.8% companies in the broader Finance sector have reported
Q2 results with earnings and revenue beat ratios coming in at 79.1%
and 77.6%, respectively. The sector has witnessed a year-over-year
earnings increase of 0.3% on 0.4% revenue growth so far. This
compares favorably with prior quarter's earnings and revenue
declines of 5.8% and 2.3%, respectively.
Banks-Major witnessed an earnings decline of 2.7% compared with a
decline of 13.6% in Q1. Banks & Thrifts however witnessed an
earnings improvement of 8.9% compared with a decline of 6.6% in Q1.
On the revenue front, Banks-Major experienced a 3.9% decline versus
5% decline in Q1. Banks & Thrifts also showed a revenue decline
of 1.8% compared with 3.2% decline in the prior
The broader Finance sector's consensus earnings expectations for Q3
and full-year 2014, however, look better with 4.8% and 2.5%
year-over-year growth rates, respectively.
For a detailed look at the earnings outlook for this sector and
others, please read our
Earnings Trends report
'Too-Big-To-Fail' Advantage Wanes, But Exists
Mega banks have been continuously benefiting from lower funding and
operating costs since the financial crisis six years ago. This is
because of the impression that Federal Reserve will always protect
these banks from failing in case of any major financial trouble.
However, the advantages have been waning in recent years.
A recent study by the Government Accountability Office found that
the market advantage for these banks declined in 2013. The
regulatory changes, particularly the 2010 Dodd-Frank law, made
these systematically important banks self-sufficient (in terms of
capital reserves) to some extent to endure any further crisis. So
the likelihood of a bailout requirement is less now.
But the biggest banks still enjoy low borrowing costs and take
bigger risks than smaller players because of the U.S. government's
'too-big-to-fail' impression, as per study by the Federal Reserve
economists in March. The study revealed that the five largest banks
have enjoyed a statistically significant 0.31% funding advantage
over their smaller peers since 2009. Further, according to a March
report by the International Monetary Fund, the 'too-big-to-fail'
tag helped these banks save $70 billion in funding costs in 2012.
We believe this malformed notion will continue to keep these banks
at an advantageous position, though less than before, for some
Does 'Problem Bank List' Indicate Any Good?
The FDIC's 'Problem List' contained 411 names as of Mar 31, 2014,
down from 467 as of Dec 31, 2013 and 884 (the highest number since
the financial crisis started) as of Dec 31, 2010. While this is no
doubt an improvement, the numbers look extremely high considering
the financial crisis six years back. There were only 76 banks on
the 'Problem List' at the end of 2007, just before the crisis.
Considering the recovery witnessed by the economy and stock markets
so far, the number of problem banks should have been much less.
This indicates that the industry is still fraught with trouble.
However, 12 banks failed during first half of 2014 compared with 16
failures in the same period last year. Total 23 banks failed in
2013 (versus 51 in 2012 and 92 in 2011) and a lesser number is
expected in 2014. Though the pace of bank failures has been
declining, the industry is still to see an average failure of just
four or five banks annually, which would indicate maximum strength
in the industry.
Growth Path Remains Bumpy
Continued narrowing of the gap between loss provisions and
charge-offs will not allow contracted provision to significantly
drive earnings in the upcoming quarters. So banks are trying to
look at other areas - primarily non-interest income and operating
costs. While cost reduction through reorganizing operations and job
cuts will support bottom line, opportunities for generating
non-interest revenues - from sources like charges on deposits,
prepaid cards, new fees and higher minimum balance requirement on
deposit accounts - would be curbed by regulatory restrictions and
still shaky economic recovery.
Efforts to cut interest expenses and take additional risks to
improve net interest margins could be marred by a still-flat yield
curve. Further, shifting assets to longer maturities for
strengthening net interest margin could backfire if the Fed decides
to increase interest rates in the near to midterm.
The persistent low-interest-rate environment has a mixed impact on
banks. While it reduced their borrowing costs, limitation to charge
high interest on loans marred revenues. When interest rates finally
start rising, benefits of banks will depend on their ability to
charge more for loans than what is paid on deposits.
However, increasing propensity to invest in the market on the back
of an improved employment scenario may create more non-interest
revenue sources. Grabbing these opportunities will require higher
overhead, so cost management needs to be more efficient to realize
As a key strategy, banks will have to resort to cost containment,
but it would act only as defense and not a concrete way to lessen
top-line pressure. The industry witnessed more than half a million
layoffs over the last five years just to stay afloat, and the story
Balance Sheet Recovery Continues
Steady deposit growth from lack of low-risk investment
opportunities is quite possible. Also, demand for loans has been
increasing with the recovering economic condition and relatively
easy lending standards. But banks have still been witnessing high
charge-offs and delinquency rates that could limit loan growth.
Moreover, though growth in gross domestic product (GDP) and
reducing unemployment will help banks strengthen their balance
sheets, reversal of interest rate environment will result in
unrealized losses on underlying securities.
However, banks are trying to reorganize risk management practices
to address potential solvency issues from rising interest rates.
Efforts are also being given to address asset-quality troubles by
divesting nonperforming assets. Yet, we don't expect balance-sheet
strength to return to pre-recession peak any time soon.
The expected near-term sluggishness in the industry and downbeat
guidance from a number of industry participants seem to have
started pricing in. So one may consider buying some bank stocks
that promise better performance based on their strong fundamentals.
Specific banks that we like with a Zacks Rank #1 (Strong Buy)
include Banc of California, Inc. (
), Bank of the Ozarks, Inc. (
), Farmers Capital Bank Corporation (
), First Community Bancshares, Inc. (
), United Financial Bancorp, Inc. (
), Farmers and Merchants Bancorp Inc. (
), MidWest One Financial Group, Inc. (
) and Central Valley Community Bancorp (
Stocks in the U.S. banking universe with a Zacks Rank #2 (Buy)
currently include BOK Financial Corporation (
), Cullen/Frost Bankers, Inc. (
), Community Trust Bancorp Inc. (
), Fidelity Southern Corporation (
), Arrow Financial Corporation (
), Community Bank System Inc. (
), Horizon Bancorp (
), Huntington Bancshares Incorporated (
) and City National Corporation (
Difficulty in liquidity management due to regulatory restrictions
will continue to restrict top-line growth of banks in the quarters
Specific banks that we don't recommend with a Zacks Rank #5 (Strong
Sell) are DNB Financial Corp. (
), First NBC Bank Holding Company (
), The Community Financial Corp. (
), Fulton Financial Corporation (
), Old Line Bancshares Inc. (
), Tristate Capital Holdings, Inc. (
), FirstMerit Corporation (
) and First Republic Bank (
). We also don't recommend a few Zacks Rank #4 (Sell) banks
including Texas Capital BancShares Inc. (
), BancorpSouth, Inc. (
), First Bancorp (
), CenterState Banks, Inc. (
) and TriCo Bancshares (
Want the latest recommendations from Zacks Investment Research?
Today, you can download 7 Best Stocks for the Next 30 Days.
Click to get this free report
UNITED FIN BCP (UBNK): Free Stock Analysis
TRISTATE CP HLD (TSC): Free Stock Analysis
COMMNTY FIN CP (TCFC): Get Free Report
TRICO BANCSHRS (TCBK): Free Stock Analysis
TEXAS CAP BCSHS (TCBI): Free Stock Analysis
BANK OZARKS (OZRK): Free Stock Analysis Report
OLD LINE BANCSH (OLBK): Free Stock Analysis
FIRST NBC BANK (NBCB): Free Stock Analysis
MIDWESTONE FINL (MOFG): Free Stock Analysis
FIDELITY SOUTHN (LION): Free Stock Analysis
HORIZON BNCP-IN (HBNC): Free Stock Analysis
HUNTINGTON BANC (HBAN): Free Stock Analysis
FULTON FINL (FULT): Free Stock Analysis Report
FIRST REP BK SF (FRC): Free Stock Analysis
FIRSTMERIT CORP (FMER): Free Stock Analysis
FARMERS&MERCHAN (FMAO): Get Free Report
FARMERS CAP KY (FFKT): Free Stock Analysis
FIRST COMM BCSH (FCBC): Free Stock Analysis
FIRST BNCRP P R (FBP): Free Stock Analysis
DNB FINANCIAL (DNBF): Get Free Report
CITY NATIONAL (CYN): Free Stock Analysis Report
CENTRAL VLY COM (CVCY): Free Stock Analysis
COMMUN TRUST BC (CTBI): Free Stock Analysis
CENTERSTATE BNK (CSFL): Free Stock Analysis
CULLEN FROST BK (CFR): Free Stock Analysis
COMMNTY BK SYS (CBU): Free Stock Analysis
BANCORPSOUTH (BXS): Free Stock Analysis Report
BOK FINL CORP (BOKF): Free Stock Analysis
BANC OF CA INC (BANC): Free Stock Analysis
ARROW FINL CORP (AROW): Free Stock Analysis
To read this article on Zacks.com click here.