U.S. Banks Stock Outlook - Jan. 2011 - Industry Outlook

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The recurrence of the intimidating 2008 meltdown is not expected for the U.S. banking industry in 2012 as the financial institutions are actively responding to every legal and regulatory pressure. In fact, this promptness has positioned the banks well to encounter impending challenges.

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

As the sector is undergoing a radical structural change, it will witness headwinds in the near- to mid-term. But entering the new capital regime will significantly improve the industry's long-term stability and security.   

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. Yet the outlook for the industry remains in question due to several negatives, including asset-quality troubles, weak revenue growth, steeper costs, continuation of both residential and commercial real estate loan defaults, weak loan demand, and the impact of tighter regulations and policy changes.

Looking back, after enduring overwhelming recessionary shocks, the U.S. banking industry has gradually started recovering. Financial support from the U.S. government ultimately transformed to stability during the year.

The government undertook several steps, including programs offering capital injections and debt guarantees, to stabilize the financial system. Also, the banks are working hard to address problem credit, primarily in residential and commercial real estate. Commercial real estate loan performance is expected to show strong improvement during 2012. However, the industry is still grappling with weak revenue, ebbing loan demand and low liquidity challenges.

Earnings Growth to Decelerate

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

Banks will definitely try to look at other areas -- interest income, non-interest income and operating costs -- to keep the earnings growth intact, but we don't see any significant opportunity with respect to top line in the upcoming quarters.

Interest income will remain under pressure due to low interest rates and a sluggish loan growth. 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 the efforts. Ultimately, banks will be forced to face lower margins. In fact, if the banks shift assets toward 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 new fees, increasing minimum balances requirement on deposit accounts and encouraging customers to use credit cards -- are expected to 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 industry 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 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 hinder loan growth. However, banks will experience steady deposit growth on the lack of low-risk investment opportunities due to the global economic turmoil and volatility in equity markets.

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

Resistance to Regulatory Challenges

Following the latest recession, the regulatory environment has become tougher and costlier for U.S. banks. During 2011, banks had to face a number of regulatory requirements under several laws, including the Dodd-Frank legislation, the Durbin Amendment and the Volcker Rule. Banks are expected to face many other regulatory headwinds in the upcoming quarters as regulators are focused 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. In the long run, though, a greater capital cushion for the larger banks will add to their ability to withstand future shocks. 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 economic data points to optimism in 2012, the economy entered the first quarter of 2012 with a lot less momentum than was earlier anticipated. Concerns have crept up in the slothful stock market momentum, exacerbated by the 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 extends further, there will be significant impact on worldwide capital markets and U.S. will not be left unscratched. Consequently, U.S. banks will 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 been hovering around record low levels. The Fed's commitment to keep the Fed Funds rate at current levels for another two years is adding to this low interest rate trend.

Bank Failures Continue

While the financials of a few large banks have been stabilizing on the back of an economic recovery, the industry is still on shaky ground. Nagging issues like depressed home prices along with still-high loan defaults and unemployment levels continue to trouble such institutions.

Lingering economic uncertainly and its effects also continue to 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. 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 hundreds of bank failures in the upcoming years. However, the worst appears to be over and the pace of bank failures is expected to be slower. Considering the course of failure last year, the number of bank failures in 2012 is not expected to exceed the 2011 tally.

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 not yet out of the woods, as there are several nagging issues that need to be addressed by the government before shifting the strategy to growth. We believe that the U.S. economy will regain its growth momentum once these are resolved.

However, before the banking sector regains investors' confidence, it is likely to meet several disappointments on the way that would offset positive developments.

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 Metrocorp Bancshares Inc. ( MCBI ), Texas Capital BancShares Inc. ( TCBI ), Viewpoint Financial Group ( VPFG ), S&T Bancorp Inc. ( STBA ), Sterling Bancorp ( STL ), First Financial Corp. ( THFF ), Privatebancorp Inc. ( PVTB ), First Community Corporation ( FCCO ), Oriental Financial Group Inc. ( OFG ), StellarOne Corporation ( STEL ), BBCN Bancorp, Inc. ( BBCN ) and Heritage Commerce Corp. ( HTBK ).  

There are currently a number of stocks in the U.S. banking universe with a Zacks #2 Rank (short-term Buy rating). These include BOK Financial Corporation ( BOKF ), Southwest Bancorp Inc. ( OKSB ), Center Bancorp Inc. ( CNBC ), Financial Institutions Inc. ( FISI ), Horizon Bancorp. ( HBNC ), Chemical Financial Corp. ( CHFC ), Park National Corp. ( PRK ), First Horizon National Corporation ( FHN ), IberiaBank Corp. ( IBKC ), First Republic Bank ( FRC ) and U.S. Bancorp ( USB ).      

WEAKNESSES

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

There are currently three stocks with a Zacks #5 Rank (short-term Strong Sell rating). These are Old Second Bancorp Inc. ( OSBC ), BofI Holding Inc. ( BOFI ) and Hanmi Financial Corporation ( HAFCD ).
 
BOK FINL CORP ( BOKF ): Free Stock Analysis Report
 
FIRST COMMTY CP ( FCCO ): Free Stock Analysis Report
 
HERITAGE COMMRC ( HTBK ): Free Stock Analysis Report
 
METROCORP BANCS ( MCBI ): Free Stock Analysis Report
 
ORIENTAL FINL ( OFG ): Free Stock Analysis Report
 
PRIVATEBANCORP (PVTB): Free Stock Analysis Report
 
S&T BANCORP INC (STBA): Free Stock Analysis Report
 
STELLARONE CORP (STEL): Free Stock Analysis Report
 
STERLING BANCRP (STL): Free Stock Analysis Report
 
TEXAS CAP BCSHS (TCBI): Free Stock Analysis Report
 
FIRST FINL-IND (THFF): Free Stock Analysis Report
 
VIEWPOINT FINL (VPFG): 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 , Business , Investing Ideas , Stocks

Referenced Stocks: BOKF , FCCO , HTBK , MCBI , OFG

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