All major U.S. banks have passed the Federal Reserve’s latest round of annual stress tests, confirming the industry’s advancement in terms of absorbing future losses. Yet there is no respite from the nagging structural pressure and weakness in a few key segments.
Despite the initial gloom, 2014 turned out fairly resilient, as cost containment and the spending of previously saved funds to cover bad loans managed to counter the stress. However, soaring legal costs -- over $25 billion transferred to the Department of Justice alone -- took a significant toll on the financials.
The recent hint from the Federal Reserve about raising interest rates later this year, though at a slower-than-expected pace, brings some hope of easing pressure on net interest margin and better mortgage activity. But this may not act as a significant support because it will take some time for rates to return to their pre-recession levels.
The demand for fresh mortgages is expected to remain depressed with fluctuations in mortgage rates and significantly lower refinancing activity. Also, there will be fewer avenues for new originations. So lenders might continue to see lower profit margins.
Wobbly trading activity, which was a downside last year too, is not likely to add significantly to revenues. In fact, though trading volumes may expand, this will have little effect on revenues thanks to customers’ increasing preference of electronic trading for saving charges.
Capital market activity is unlikely to show any significant improvement in the upcoming quarters, with no clear direction of market volatility. But the issuance volume should show an uptrend with market recovery.
Though overall loan growth is expected to remain tepid, banks will continue to witness improving trends in the areas of auto, credit card and student lending with an improving economy. Also, a pickup in commercial real-estate lending has helped banks with significant exposure. Further, the boom in M&A and IPO activities is leading to solid investment banking business.
Legal costs are now part and parcel of bank financials. Legalities are particularly acute for a few big banks -- including Bank of America Corp (NYSE:BAC), JPMorgan Chase & Co (NYSE:JPM), Citigroup Inc (NYSE:C). and Wells Fargo & Company (NYSE:WFC). Among the $25 billion that went to the Department of Justice in 2014, a large part was shelled out by Citigroup and Bank of America for settlements.
With increasing regulatory scrutiny on the business model, banks are not expected to get rid of such expenses, at least in the near term. However, renewed settlement efforts by banks should take the burden off somewhat.
Along with a tough operating environment, too many mandatory defensive measures -- such as maintaining higher capital ratios -- are thwarting growth. Further, advanced technology requirements, primarily for cyber security, are eating away a large share of funds. This, along with investments for new revenue sources, will keep any remarkable bottom-line improvement in check in the quarters ahead.
However, banks have been trending toward higher fees to dodge the pressure. Easing lending standards after complying with regulatory guidelines has also become a trend. Continued expense control and balance sheet restoration should also act as tailwinds in the upcoming quarters. Further, a favorable equity and asset market backdrop plus supportive macroeconomic factors -- such as falling unemployment and a progressive housing sector -- should pave way for stability.
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 industry.
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) http://www.zacks.com/stocks/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-Southeast is #67, Banks-Midwest is #70, Banks-West is #98, Banks-Major Regional is #99, Banks-Northeast is #107 and Banks-Southwest is #164. Considering the Zacks Industry Rank of the six banking industries, one could safely say that the outlook for the group is ‘Neutral.’
Earnings Outlook
First-quarter 2015 earnings season for the banking sector will kick off in mid-April. Earnings estimates for stocks in the S&P 500 index call for better year-over-year performance of the Finance sector compared with the concluding quarter of 2014.
Earnings and revenue beat ratios (percentage of companies coming out with positive surprises) for the broader Finance sector came in at 64.2% and 59.3%, respectively, in the last quarter of 2014. The sector witnessed almost stable earnings compared with the year-ago quarter, while revenues grew about 1%.
The sector’s consensus earnings expectations for Q1 look better, with a 9.5% year-over-year growth rate. However, the sector is expected to see a revenue decline of 4.5%.
For a detailed look at the earnings outlook for this sector and others, please read our latest Earnings Trends report. http://www.zacks.com/commentary/38725/3-things-to-know-about-q1-earnings-season
The Road Ahead
The industry is not likely to return to its pre-recession glory anytime soon. But what encourages us is that the U.S. banks are getting accustomed to increased legal and regulatory pressure and resorting to safer alternatives for higher returns. However, structural changes in the sector will continue to impair business expansion and investor confidence for some time.