U.S. banks are on the verge of releasing their first-quarter 2014 results, which are likely to reflect the tough backdrop endured since the beginning of the year. The quarter remained challenging with dreary consumer and corporate activities, soft trading volumes, sluggish mortgage banking activities, and high legal costs. Further, reserve release is not expected to be strong enough to support bottom-line growth similar to the past year.
Overall, U.S. banks are apparently losing their luster with too many mandatory defensive measures thwarting growth. Moreover, top-line growth remains uncertain as a dearth of significant loan growth (primarily the home equity lines of credit) and pressure on net interest margins from a nagging low rate environment, prevail.
However, banks have been gradually easing their lending standards and trending toward higher fees to dodge the pressure on the top line. Then again, continued expense control and stable balance sheets should act as tailwinds in the upcoming quarters. Further, a favorable equity and asset market backdrop, and favorable macroeconomic factors – such as falling unemployment, a progressive housing sector and flexible monetary policy – should pave way for stability. Of course, financial institutions that depend less on risky activities and resort to other profit-making ways seem to have a brighter future.
Now that the interest rate environment has reached a reversal point with the Fed’s tapering of fiscal stimulus, net interest margins are likely to improve and support top line to an extent. But revenues from mortgage fees will lessen as the boom in mortgage refinancing fizzles out. Whether the loss of fee revenues will be compensated by gains from interest rate spreads can however be said only in the course of time.
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 earnings. This indicates their ability to encounter challenges and grow at a moderate pace. 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 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.
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 #14, Banks-West is #34, Banks-Midwest is #38, Banks-Southeast is #58, Banks-Northeast is #86, and Banks-Major Regional is #94. Considering the Zacks Industry Rank of the six banking industries, one could safely say that the outlook for the group is leaning toward 'Positive.’
Earnings Preview of the Broad Sector
The broader Finance sector, of which U.S. banks are part, is expected to witness year-over-year earnings decline in first-quarter 2014.
The sector’s earnings are expected to decline 3.9% compared with 22.8% growth in the preceding quarter. On the revenue front, a 7.3% decline is expected, compared to a 12.4% plunge in the prior quarter.
Though the numbers for the 7 medium-level (or M-level) industries in the sector will most likely be positive, the growth rates are mostly expected to decline. Particularly, Major Banks and Banks and Thrifts are expected to witness 6.8% and 15.2% decline, respectively.
Among major Industry players, JPMorgan Chase & Co. (NYSE:JPM), The Goldman Sachs Group, Inc. (NYSE:GS) and Citigroup Inc. (NYSE:C) are expected to experience year-over-year earnings declines.
The consensus earnings expectations for full-year 2014 and 2015, however, look decent with 5.5% and 11.2% growth rates, respectively.
‘Too-Big-To-Fail' Advantage
Mega banks have been continuously benefiting from lower funding and operating costs since the financial crisis. This is because of the impression that the Federal Reserve will always protect these banks from failing in case of any major financial trouble.
A recent study by Federal Reserve economists suggests that 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 about them. The study estimated that the five largest banks have enjoyed 0.31% funding advantage over their smaller peers since 2009. This is statistically significant according to the researchers.
This malformed notion will continue to keep these banks at an advantageous position unless anything unfavorable happens.
Does the ‘Problem Bank List’ Indicate Anything Good?
The unofficial number of banks on the FDIC's ‘Problem List’ increased to 533 as of April 4, 2014 from official number of 467 as of December 31, 2013. There were 515 problem banks as of September 30, 2013.
The numbers look extremely high considering that the financial crisis happened five 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.
During first-quarter 2014, just 5 banks have failed. Though the number compares unfavorably with 4 failures in the first quarter of 2013, it still looks decent.
Though fewer bank failures are expected in 2014 compared to 2013, 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 Will Not Be Easy
As the gap between loss provisions and charge-offs is gradually narrowing, reduction in provisions is not likely to remain a significant earnings driver in the upcoming quarters. So banks are trying to look at other areas -- primarily non-interest income and operating costs. But opportunities will be curbed by regulatory restrictions and a 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 with the expected increase in interest rates in the near to mid term.
The low-interest-rate environment following the financial crisis has a mixed impact on banks. While it reduced their borrowing costs, limitation to charging 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.
On the other hand, increasing revenues through non-interest sources -- charges on deposits, prepaid cards, new fees and higher minimum balance requirement on deposit accounts -- could be hampered by regulatory actions and soaring overhead. However, with a rebound in capital market activity, the propensity to invest in the market has increased, which may lead to more non-interest revenue sources.
Eventually, banks will have to resort to cost containment through job cuts and reduced operational size. But any cost-cutting measure will act as a defense. The industry witnessed more than half a million layoffs over the last five years just to stay afloat, and the story will continue.
Is Balance Sheet Recovery On Track?
Steady deposit growth from lack of low-risk investment opportunities is quite possible, but high charge-offs and delinquency rates plus weak demand could keep loan growth under pressure in the near to mid term. Though banks are easing lending standards to accelerate loan growth, credit quality concerns are likely to mar the effort.
Moreover, though growth in gross domestic product (GDP) and reducing unemployment will help banks strengthen their balance sheets, expected unrealized losses on underlying securities due to a likely rise in interest rates will act as dampeners.
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 anytime soon.
Opportunities
The expected near-term sluggishness in the industry seems to have started pricing in. So it is perhaps the right time to add some banking stocks with strong fundamentals to your portfolio.
Specific banks that we like with a Zacks Rank #1 (Strong Buy) include Farmers and Merchants Bancorp Inc. (FMAO), Capital City Bank Group Inc. (CCBG), Farmers Capital Bank Corporation (FFKT), IberiaBank Corp. (IBKC), First Financial Corp. (THFF), Peoples Bancorp Inc. (PEBO), Central Pacific Financial Corp. (CPF) and SVB Financial Group (SIVB).
Stocks in the U.S. banking universe with a Zacks Rank #2 (Buy) currently include BankUnited, Inc. (BKU), Wells Fargo & Company (NYSE:WFC), Tompkins Financial Corporation (Tompkins Financial Corporation (AMEX:TMP), BancorpSouth, Inc. (BXS), Synovus Financial Corporation (NYSE:SNV), Associated Banc-Corp (ASBC) and Commerce Bancshares, Inc. (CBSH).
Weakness
Difficulty in liquidity management due to regulatory restrictions will continue to restrict top-line growth of banks in the quarters ahead.
Specific banks that we don't like with a Zacks Rank #5 (Strong Sell) are Republic Bancorp Inc. (RBCAA) and North Valley Bancorp (NOVB). We also don’t recommend a few Zacks Rank #4 (Sell) banks including Bank of America Corporation (NYSE:BAC), Chicopee Bancorp, Inc. (CBNK), OFG Bancorp (OFG), Regions Financial Corporation (NYSE:RF), Trustmark Corporation (TRMK.O)), Park National Corp. (AMEX:PRK)), Bank of Hawaii Corporation (BOH) and Texas Capital BancShares Inc. (TCBI.O)).