U.S. Banks Stock Outlook - August 2012 - Industry Outlook

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Barring an expected slowdown in loan growth, U.S. banks appear well placed to perform steadily through the remainder of 2012 on uninterrupted expense control and a contraction in provisions for credit losses. At least the progress seen in the first half of the year gives us this indication.

Marked recovery of the bond and equity markets and consequent revenue growth pushed the first quarter results a bit higher than expected, but the second quarter failed to impress with respect to top-line growth due to a decelerating economy. A combination of factors -- subdued federal spending, ongoing European crisis and tax law uncertainty following the presidential election -- kept revenue and trading income under pressure. However, core dynamics showed strength throughout the first half.

Moreover, U.S. banks are actively responding to every legal and regulatory pressure, indicating the fact that they are well positioned to encounter impending challenges. In addition, taking advantage of the growing demand for loans from large- and medium-sized businesses, U.S. banks have been easing their lending standards in order to boost loan growth.

However, the potency of the sector is not expected to return to its pre-recession peak anytime soon. The economic intricacies, both domestic and overseas, may even result in further disappointments in the upcoming quarters.

A decelerating growth rate of the U.S. gross domestic product (GDP) (annualized growth came in at 1.5% in the second quarter of 2012, slowing sharply from 2% in the first quarter and 4.1% in the fourth quarter of 2011) and slowing demand from businesses related to real-estate will continue to restrict revenue growth.

Also, as the sector is undergoing a radical structural change, it will witness continuous headwinds related to business expansion and investor confidence. But entering the new capital regime will ensure stability and security in the industry over the long term.

Looking back, the government undertook several steps, including capital injections and debt guarantees, to rescue the U.S. banks from the effects of the financial crisis in 2008 and 2009. The banks are also working hard since then to address problem credit, primarily in residential and commercial real estate. Though financial support from the government and banks' efforts ultimately transformed into stability, the sector has a long way to go before bouncing back to its pre-recession glory.     

Along with increasing earnings, a major recovery in the asset markets, improving balance sheets and declining credit costs promise growth for the U.S. banking sector, though at a slower-than-normal pace. The dampening factors -- issues related to the mortgage liabilities, asset-quality troubles, weak loan growth and the impact of tighter regulations and policy changes -- are expected to remain tied to the fate of the U.S. banks in the upcoming quarters.

Profitability Remains Challenged

Though reduced loss provisioning has helped the industry witness strong earnings growth over the last couple of years, we don't expect a significant pickup in the upcoming earnings from provision reductions, as the difference between loss provisions and charge-offs is gradually decreasing.

Banks will definitely try to look at other areas -- interest income, non-interest income and operating costs -- to keep the earnings growth intact, but there is no significant opportunity that can boost top-line growth in the upcoming quarters.

Interest income will remain under pressure due to low interest rates and sluggish loan growth. After accelerating for 10 straight months, loan growth slowed in July 2012 and is expected to continue falling in the coming months due to a feeble macro economy. Though banks will try to cut interest expenses and take additional risks to improve net interest margins, the flattening of the yield curve will mar these efforts.

Ultimately, banks will be forced to face lower margins. In fact, if the banks shift assets to longer maturities to keep net interest margin strong, this could backfire once interest rates start rising.

On the other hand, attempts to boost revenues through non-interest sources -- introducing prepaid cards, imposing new fees, increasing minimum balance requirements on deposit accounts and encouraging customers to use credit cards -- could be hampered by ongoing regulatory actions, a volatile global economy and soaring overhead. So, non-interest income will be able to marginally contribute to total revenue.

Lower revenue will finally force these banks to cut costs in order to stay afloat. As a result, banks will continue cutting jobs and reducing the size of operations by selling non-core assets. So, any cost-cutting measure will act as a defense.

Balance Sheet Recovery to Take Time

Since last year, banks have been trying to address asset-quality troubles through the disposition of nonperforming assets. Also, non-core asset shedding has become an industry trend as banks have no other alternative but to keep capital ratios above regulatory requirements.

This non-core asset-selling, along with elevated charge-offs and weak demand, will likely keep loan growth under pressure in the near to mid-term. Moreover, heightened regulatory restrictions and soaring delinquency rates will act as headwinds. However, banks will experience steady deposit growth due to the lack of low-risk investment opportunities following the global economic turmoil and volatility in equity markets.

So we don't expect a significant strength in balance sheets to return anytime soon.

Regulatory Threats Lingering

Following the latest recession, the regulatory environment has become tougher and costlier for U.S. banks. In the last several quarters, banks had to face a number of regulatory requirements under several laws, including Dodd-Frank legislation, the Durbin Amendment and the Volcker Rule.

Many other regulatory requirements are expected to hinder growth in the upcoming quarters as regulators focus on global alignment. Though the aim is to meaningfully change the business models of banks to make them self-sufficient over the longer term, the cost of compliance will drag down profitability in the near- to mid-term.

While the implementation of the Basel III requirements will boost minimum capital standards, there will be a short-term negative impact on the financials of U.S. banks as they will have to adjust their liquidity management processes. But a greater capital cushion for the larger banks will add to their ability to withstand internal and external shocks in the long run. However, banks will get the time to strengthen their capital position as the Basel III requirements will be gradually introduced during the 2013 to 2019 period.

Macroeconomic Headwinds

There are several macroeconomic factors that may weigh on the profitability of the U.S. banks. The most crucial among these is the uncertain outlook for the U.S. economy.

Though improved economic data such as steady consumer spending and relatively lower unemployment point towards optimism, the economy has witnessed a lot less momentum in the first half of 2012 than was anticipated. Concerns have crept up in the slothful stock market, exacerbated by ongoing concerns related to the European debt crisis.

Though the U.S. commercial banks appear to have significant direct and indirect exposure to Europe, the potential costs are expected to be manageable. However, if the crisis deepens, there will be significant impact on worldwide capital markets, and the U.S. will not be left unscathed. Consequently, U.S. banks would then face increased challenges.  

On the other hand, the extremely low interest-rate environment is another manifestation of this uncertain macro backdrop. Concerns about European finances and soft U.S. growth prospects have made treasury instruments the choice of safe asset class. As a result, yields on benchmark treasury bonds have hovered at low levels.

Bank Failures Continue

While the financials of a few large banks are stabilizing on the back of economic stability and increasing dependence on noninterest revenue sources, the industry is still on shaky ground. The sector presents a picture similar to that of 2011, with nagging issues like depressed home prices, still-high loan defaults and unemployment levels troubling such institutions.

The lingering economic uncertainty and its effects also weigh on many banks. The need to absorb bad loans offered during the credit explosion has made these banks susceptible to severe problems.

Furthermore, government efforts have not succeeded in restoring lending activity at the banks. Banks are also trying to boost lending activity by easing lending standards, but sufficient loan growth is not expected anytime soon given the weak real-estate market.  Lower lending will continue to hurt margins, though the low interest rate environment should be beneficial to banks with a liability-sensitive balance sheet.

Increasing loan losses on commercial real estate could trigger many more bank failures in the upcoming years. However, considering the moderate pace of bank failures, the 2012 number is not expected to exceed the 2011 tally. From 2012 through 2016, bank failures are estimated to cost the Federal Deposit Insurance Corporation (FDIC) about $12 billion.

Eventually, the strong banks will continue to take advantage of strategic opportunities, with the big fish eating the little ones.

Conclusion

Clearly, the banking system is still not out of the woods, as there are several nagging issues that need to be addressed. Banks will also have to stay away from risky activities for immediate benefit.

Given the progress in the industry so far, it seems that banks may encounter several disappointments ahead before gaining investors' confidence. In fact, the negatives could offset the positive developments to a great extent.

OPPORTUNITIES

The regulatory requirement of focusing on banking institutions toward higher-quality capital will help banks absorb big losses. Though this would somewhat limit the profitability of banks, a proper implementation would bring stability to the overall sector and hopefully keep bank failures in check.

Specific banks that we like with a Zacks #1 Rank (short-term Strong Buy rating) include Enterprise Financial Services Corp. ( EFSC ), Heartland Financial USA Inc. ( HTLF ), Taylor Capital Group Inc. ( TAYC ), Access National Corp. ( ANCX ), Community Trust Bancorp Inc. ( CTBI ), First Bancorp ( FBP ), BofI Holding Inc. ( BOFI ), North Valley Bancorp ( NOVB ), Premierwest Bancorp ( PWRT ), Eagle Bancorp, Inc. ( EGBN ), Horizon Bancorp. ( HBNC ) and United Financial Bancorp, Inc. ( UBNK ).  

There are currently a number of stocks in the U.S. banking universe with a Zacks #2 Rank (short-term Buy rating). These include Huntington Bancshares Incorporated ( HBAN ), Old National Bancorp. ( ONB ), Regions Financial Corp. ( RF ), Fidelity Southern Corporation ( LION ), TriCo Bancshares ( TCBK ), Central Pacific Financial Corp. ( CPF ), Bank of Hawaii Corporation ( BOH ), Community Bank System Inc. ( CBU ), First Commonwealth Financial Corp. ( FCF ), Signature Bank ( SBNY ), Washington Trust Bancorp Inc. ( WASH ), BOK Financial Corporation ( BOKF ), Texas Capital BancShares Inc. ( TCBI ), Fifth Third Bancorp ( FITB ), KeyCorp ( KEY ), M&T Bank Corporation ( MTB ) and U.S. Bancorp ( USB ).  

WEAKNESSES

The financial system is going through massive deleveraging, and banks in particular have lower leverage. The implication for banks is that profitability metrics (like returns on equity and return on assets) will be under pressure.

There are currently four stocks with a Zacks #5 Rank (short-term Strong Sell rating). These are Seacoast Banking Corp. of Florida ( SBCF ), Washington Banking Co. ( WBCO ), Hudson Valley Holding Corp. ( HVB ) and International Bancshares Corporation ( IBOC ).
 
ACCESS NATL CP (ANCX): Free Stock Analysis Report
 
BOFI HLDG INC (BOFI): Free Stock Analysis Report
 
COMMUN TRUST BC (CTBI): Free Stock Analysis Report
 
ENTERPRISE FINL (EFSC): Free Stock Analysis Report
 
EAGLE BCP INC (EGBN): Free Stock Analysis Report
 
FIRST BNCRP P R (FBP): Free Stock Analysis Report
 
HUNTINGTON BANC (HBAN): Free Stock Analysis Report
 
HORIZON BNCP-IN (HBNC): Free Stock Analysis Report
 
HEARTLAND FINCL (HTLF): Free Stock Analysis Report
 
NORTH VALLEY BC (NOVB): Free Stock Analysis Report
 
OLD NATL BCP (ONB): Free Stock Analysis Report
 
TAYLOR CAP GRP (TAYC): Free Stock Analysis Report
 
UTD FINL BCP (UBNK): Free Stock Analysis Report
 
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: ANCX , BOFI , CTBI , EFSC , GDP

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