Foreign banks have been facing difficulties non-stop since the latest financial crisis, which triggered off as a credit issue in the subprime enclave of the U.S. mortgage market in mid-2007, and spilled all over the globe. The latest deterrents –– nagging macroeconomic issues, the European sovereign debt crisis in particular, and regulatory pressure –– also resulted in the sector’s latest underperformance.
Moreover, the upcoming quarters look even worse with several negatives like asset-quality troubles, weak revenue growth, steeper costs and weak loan demand. But thanks to the worldwide regulatory reform, the sector has at least entered a transformation phase. Needless to mention, a change is yet to be felt.
The sector entered 2012 with a lot less momentum than anticipated. Rising concerns related to funding and limited access to market along with other fundamental challenges are not expected to bring stability anytime soon.
A Fundamental View
Looking at the fundamentals, a rising risk aversion tendency has been gradually reducing client activity, resulting in lower trading volumes and subdued credit demand. Also, learning from past experience, banks are now more cautious to lend money. Consequently, lower business activities and expected subdued profitability are making foreign banks less attractive to investors. Valuation multiples of foreign banks will continue to reflect the fundamental challenges through 2012.
Though the growth potential of some non-U.S. banks could be subdued due to higher reserve requirements, increased property taxes and strict lending limits as part of the regulatory overhaul, as well as greater transparency in regulations could strengthen the fundamentals of many banks. Eventually, these are expected to create a less risky lane for the overall industry.
Moreover, as inter-country investment walls have fallen, some large non-U.S. banks are freely expanding beyond their domestic boundaries through mergers and acquisitions.
In fact, the sector saw a moderate recovery in 2010, but performance in 2011 was one of the poorest in history. Difficulties notwithstanding, the malice spread by the financial crisis is behind us.
Now, the primary headwind for global banks is regulatory pressure, which ensued from taxpayers' money and government intervention that these had to fall back on in order to remain afloat. Moreover, government efforts to alleviate industry concerns have significantly raised political hurdles over time.
Politics will continue to influence lending decisions of banks for as long as these remain financially dependent on governments. According to banking regulators, if governments withdraw their support from banks before giving them sufficient time to restore their financial strength, the sector could collapse again.
The industry has been adopting tougher regulatory measures to prevent the recurrence of a global financial crisis and restore public confidence. In June 2011, the oversight body of the Basel Committee on Banking Supervision proposed new rules that would force the world's biggest banks to hold extra capital on their balance sheets as protection and prevention against any financial catastrophe.
This extra capital requirement is an addition to the set of minimum capital standards, known as Basel III, proposed by regulatory officials of more than two dozen countries in 2010.
Additionally, the governments in Germany and France require a new financial transaction tax and risk weighted asset clarification. This may further lower the financial flexibility of banks in these countries.
With these regulatory measures, the individual capital structures of banks will remain under constant pressure. The resulting slowdown at some big banks could be seen as a blessing in disguise as it would eventually make their balance sheets more recession-proof.
Valuations Look Attractive
Balance sheet repair and credit environment recovery will make the valuations of some non-U.S. banks attractive. Particularly, valuations of the mega banks, which could comfortably maintain the minimum capital norms mandated by the Basel Committee, will experience the fastest valuation upside. Consequently, we believe this would be the perfect time for mid- to long-term investors to consider non-U.S. bank stocks, as their valuations are now comparatively cheap.
Investors with short-term targets, however, should be very careful while choosing non-U.S. bank stocks at this point as near-term fundamentals remain weak. Asset quality lacks the potential to rebound anytime soon as default rates for individuals and companies are not expected to materially subside, and revenue growth might remain weak with faltering loan growth.
The sector is not expected to witness a turnaround at least in 2012. If any improvement occurs, it will vary from country to country, depending on industry circumstances. We believe that banks in emerging economies –– Chile, Brazil or India –– look more attractive, akin to certain regional banks in the U.S., Australia and Canada that have capital strength, good funding and growth potential.
Woes in the Eurozone
The same, however, cannot be said of European institutions. European banks are most likely to underperform in the upcoming quarters primarily due the ongoing debt crisis in the nation and resulting capital pressure and deleveraging risk.
In early 2010, the debt crisis originating in the Greek economy shook the stability of the European Union's (EU) monetary policies. Starting as a solvency crisis in a single country, the turmoil spread over to the entire Euro-zone.
The situation did not stabilize to a great extent in 2011 despite financial assurance from the European Union leaders. Entering 2012, the European debt crisis has heightened spreading fears of a financial collapse in the continent.
Though Italy and Spain showed signs of improvement with support from the government and European Central Bank, conditions in Greece remain uncertain due to issues related to additional bailout funds.
Moreover, the high inflation will continue to force regulators to tighten their policies in the Euro-zone, making banks less flexible.
Overall, the European Union is trying hard not just to restore investor confidence but also the health of the continent’s banking system. The issue, however, remains far from being satisfied.
Coming to banks in emerging economies, the asset quality trouble is obvious. However, these are not plagued by other serious problems that many of the larger banks face in continental Europe and the United Kingdom, such as toxic securities and dilution from capital raising. Moreover, these emerging-market banks generally tend to be well capitalized, aren't as heavily exposed to property markets, and have significant and growing sources of non-interest income.
Overall, a key determinant for quick recovery will be the quality of risk analysis and risk-awareness in decision-making and incentive policies. So, we believe that accumulating larger capital buffers over the cycle and reducing pointless complexity in business will be crucial to banking performance.
Also, the primary attention of policymakers should be on determining how much longer the fiscal stimulus should continue, ensuring that it is not withdrawn before a clearer sign of economic recovery is visible.
Among the non-U.S. banks, we recommend HDFC Bank Limited (HDB - Analyst Report), National Australia Bank Limited (NABZY - Snapshot Report), National Bank of Canada (NTIOF - Snapshot Report), Shinhan Financial Group Co Ltd. (SHG - Snapshot Report) and Westpac Banking Corporation (WBK - Snapshot Report) with a Zacks #1 Rank (short-term Strong Buy rating).
Banks with a Zacks #2 Rank (short-term Buy rating) that we also like include Banco Bilbao Vizcaya Argentaria (BBVA), Itau Unibanco Banco Holding SA (ITUB - Analyst Report), ICICI Bank Limited (IBN - Analyst Report), Royal Bank Of Canada (RY - Snapshot Report) and Toronto Dominion Bank (TD - Snapshot Report).
We also like a few Zacks #3 Rank stocks such as Banco Bradesco (BBD), Banco Latinoamericano (BLX), Banco Macro S.A. (BMA - Snapshot Report), Bank Of Montreal (BMO - Snapshot Report), Bank Nova Scotia (BNS - Snapshot Report), Barclays PLC (BCS), Canadian Imperial Bank of Commerce (CM), Credicorp Ltd. (BAP), KB Financial Group Inc (KB), Lloyds Banking Group Plc (LYG), Mitsubishi UFJ Financial Group (MTU), Natl Bk Greece (NBG) and UBS AG (UBS).
We would suggest avoiding European banks at this point. Also, it is better to steer clear of banks in Great Britain and Ireland, in particular those that have participated in government recapitalization programs and have yet to reimburse the money. In return for government capital and asset quality protection, these banks are facing regulatory intervention, like enforcing limits on dividend payouts and board member nominations.
Currently, banks that we dislike with the Zacks #5 Rank (short-term Strong Sell rating) include BNP Paribas (BNPQY), Credit Suisse Group (CS) and Societe Generale Group (SCGLY).
We also dislike some stocks in the non-U.S. bank universe with the Zacks #4 Rank (Sell), namely Banco De Chile (BCH), BBVA Banco Frances S.A. (BFR), BanColombia S.A. (CIB), Banco Santander - Chile (SAN), Banco Santander, S.A. (STD), Deutsche Bank AG (DB), HSBC Holdings Plc. (HBC) and Mizuho Financial Group, Inc. (MFG).