Earnings performance by U.S. banks in the recent quarters has no doubt been encouraging, but this is primarily an outcome of the defensive measures that they have resorted to tide over the financial meltdown. While banks are working out ways to reduce their dependence on defensive measures through aggressive strategies, burning issues like cybercrime, regulatory compliance and unconventional competition will keep their financials strained.
Banks are trying every means to contain costs, either by closing lackluster operations or by laying off personnel. Yet nonstop legal expenses plus higher spending on cyber security, analytics and alternative business opportunities are costing a pretty penny.
Added to these is the inconsistent performance by the key business segments and dull top-line growth.
The dearth of overall loan growth and consequent pressure on net interest margin remains prominent with liquidity coverage rule (LCR) requirements and intense competition. Though the impending interest rate hike should ease some pressure, there will be no significant changes on the net interest margin front in the near term given the Fed’s plan to raise rates at a slower pace.
In an earlier piece (Will Rate Hike Secure Steady Growth for U.S. Banks?), we provided arguments in favor of investing in the U.S. banks’ space. But here we would like to argue the opposite case.
Interest Rate Hike May Not Turn as Favorable as Expected
Banks will benefit from rising interest rates only if the increase in long-term rates is higher than the short-term ones. This is because banks will have to pay less for deposits (typically tied to short-term rates) than what they charge for loans (typically tied to long-term rates). This opposite case will actually hurt net interest margin.
Banks will not have to compete for deposits and pay higher rates for some time, as they already have excess deposits that they gathered by capitalizing on the lack of low-risk investment opportunities in a low-rate environment. However, the excess deposits will dry up after some time. And if short-term rates are higher than the long-term ones, the interest outflow for maintaining the required deposits will be higher than the inflow of the same from loans.
On the other hand, credit quality -- an important performance indicator for banks -- should improve with the interest rate hike. But the prolonged low interest rate environment has forced banks to ease underwriting standards for long. This, in turn, has increased the chance of higher credit costs for quite some time.
Capital Buffers May Fall Short in Absorbing Future Losses
U.S. accounting rules allow banks to record a small part of their derivatives and not show most mortgage-linked bonds. So there might be risky assets off their books. As a result, the capital buffers that U.S. banks are forced to maintain might not be enough to fight the risks of a default.
Strengthening Revenue Won't Be Easy
Banks’ strategies to focus more on non-interest revenue sources for strengthening their top line have not been smooth sailing. Opportunities for generating non-interest revenues -- from sources like charges on deposits, prepaid cards, new fees and higher minimum balance requirement on deposit accounts -- will continue to be curbed by regulatory restrictions.
While the greater propensity to invest in alternative revenue sources on the back of an improved employment scenario might result in higher non-interest revenues, grabbing good opportunities will require a higher overhead.
Quality of Earnings a Concern
Better-than-expected earnings have been the key drivers of banks’ performance in the last few quarters, but the surprises have mostly been helped by conservative estimates. Promising low and then impressing the market with an earnings beat is the trend.
Also, the way of generating earnings seems a stopgap. Measures like forceful cost reduction and lowering provision may not last long as earnings drivers. Further, continued narrowing of the gap between loss provisions and charge-offs will not allow banks to support the bottom line by lowering provision.
Moreover, competing with other industry participants to grab new business opportunities would require significant spending and increase costs.
Unless the key business segments revitalize and generate revenues that could more than offset the usual growth in costs, bottom-line growth will not be consistent.
Stocks to Stay Away From
As you can see, there are still a number of reasons to worry about the industry’s performance going forward. So it would be prudent to get rid of or stay away from some bank stocks that depict weak fundamentals and carry an unfavorable Zacks Rank.
We don't recommend Wilshire Bancorp Inc. (WIBC), MidSouth Bancorp Inc. (MSL), The Community Financial Corp. (TCFC) and Independent Bank Group, Inc. (IBTX), as they carry a Zacks Rank #5 (Strong Sell).
(Check out our latest U.S. Banks Stock Outlook for a more detailed discussion on the fundamental trends and the position of this important sector from an earnings perspective.)
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