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Top-Line Concerns May Weigh on Optimism Over Bank Stocks

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An unstable top line is primarily responsible for the earnings weakness that the banking industry has been witnessing for the last few quarters. And investors’ concerns in this regard could tarnish the optimism over the benefits due for banks from the reforms and the monetary policy changes.

In fact, the continued weak backdrop, which has been putting pressure on the financials of banks, could shift investors’ focus from the industry in the near term. So, until the benefits from the expected change in regulations or the Fed’s actions are tangible, banks stocks might perform erratically.

Also, investors’ enthusiasm may wane if the actual benefits don’t meet investors’ expectations or take too long to come. As a result, there could be downward pressure on bank stocks that were flying high just based on the expected benefits.

While there is no indication of disruption in the interest rates moving higher, the Trump administration is yet to make any tangible progress on the reforms front. As political oppositions reduce chances of a full-scale regulatory reform, only smaller adjustments appear feasible for now. While any adjustments to existing regulations would be favorable for banking business, they may fail to meet investors’ expectations.

 

Moreover, softer regulations might benefit banks earning mostly from domestic operations. However, larger banks with significant international exposure might lose out on competitiveness due to ever-increasing international regulatory standards. Further, meeting international standards will restrict them from generating domestic revenues.

 

Though it is too early to make any negative assessment of the likely financial policy changes, easier lending standards and lesser regulatory restrictions could increase credit costs for banks, similar to what the industry witnessed just before the recession.

Moreover, while the expected rate hikes and Trump’s pro-growth and business-friendly approach will instill some fresh energy into the banking business, there are a number of fundamental challenges to hold banks back from growing steadily.

Expense reduction was the key measure that helped banks stay afloat in the past few quarters. But it may not be a major support going forward, as banks have already cut the majority of unnecessary expenses.

Banks’ proactive actions to move beyond defensive steps like cost containment were also effective in supporting their bottom line over the last few quarters. However, these are not enough to make the growth path steady, as emerging issues like cybercrime and unconventional competition (from fintech and other technology firms) are piling up.

While results for the last few quarters show some respite from high legal costs, higher spending on cyber security, technology, analytics and alternative business opportunities will cost a pretty penny.

In an earlier piece (U.S. Bank Stocks Set to Rally Despite Decelerating Earnings), we provided arguments in favor of investing in the U.S. banking space. But here we would like to discuss some points that substantiate the opposite case.

Quality of Earnings Is Getting Inferior

Banks have been delivering better-than-expected earnings for quite some time now, but the positive surprises have mostly been backed by conservative estimates. Promising low and then impressing the market with an earnings beat has been the tactic.

While year-over-year comparisons remained positive over the last several quarters, the industry witnessed decelerating growth rates.

Also, the way of generating earnings looks like a stopgap. While there is limited scope to reduce expenses further, lowering provisions may not last long. Continued narrowing of the gap between loss provisions and charge-offs will not allow banks to support the bottom line by lowering provisions.

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.

Non-Interest Revenues Falling Short

Banks’ strategies to generate more revenues from non-interest sources are working well, but the sources are not yet dependable. So, non-interest revenues are not yet enough to give a solid boost to the top line.

Moreover, 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 greater propensity to invest in alternative revenue sources on the back of an improved employment and wage scenario might result in higher non-interest revenues, grabbing good opportunities will require a higher overhead.

Benefits from Higher Rates May Fail to Meet Expectations

In order to survive in the prolonged low interest rate environment, banks reduced their dependence on rate-sensitive revenues and focused more on alternative revenue sources. So, rising rates may not immediately benefit banks as much as they did in the pre-crisis period.

On the other hand, with interest rates rising, banks will benefit only if the increase in long-term rates are 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). The opposite case would 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 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 the competition for deposits will increase as a consequence of the Fed’s balance sheet unwinding. In that case, 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 from loans.

Further, credit quality, an important performance indicator for banks, may not improve with rising interest rates if there is lesser regulatory supervision. The prolonged low interest rate environment has already forced banks to ease underwriting standards, which, in turn, has increased the odds of higher credit costs.

It Could Be Difficult to Absorb Future Losses

In the United States, 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, capital buffers that U.S. banks have been forced to maintain so far might not be enough to fight risks of a default. Likely lesser restriction on capital under the Trump administration would make dealing with a default even more difficult.

Also, if the troubled sectors that banks are exposed to by lending significant money witness any further deterioration, banks will have to build up more cash reserves to cover their losses. This will have a significant impact on earnings. On the other hand, prohibiting troubled borrowers from their loan portfolio could end up damaging more, as it would reduce the chance of repayment of the money that they have already lent.

Stocks to Stay Away from

Despite the expected benefits from the reforms and rising interest rates, there are a number of reasons to worry about the industry’s performance in the near to medium term. So it would be prudent to get rid of or stay away from some weak bank stocks for now. Stocks carrying an unfavorable Zacks Rank are particularly expected to underperform.

Here are a few stocks that you should stay away from:

F.N.B. Corporation (FNB): This Zacks Rank #5 (Strong Sell) stock lost more than 5% over the last six months versus the S&P 500’s gain of 7.6%. The stock’s earnings estimates for the current year have been revised 2.1% downward over the last 30 days.

Hilltop Holdings (HTH - Free Report) : A 2.6% downward revision in earnings estimates for the current year over the last 30 days precipitated a Zacks Rank #5 for this stock. The stock lost more than 15% in the past six months.

First Financial Northwest (FFNW - Free Report) : This Zacks Rank #5 stock gained 1.2% over the past three months. The stock’s earnings estimates for the current year have been revised 2.3% downward over the last 30 days.

First Business Financial Services (FBIZ - Free Report) : More than 8% downward revision in earnings estimates for the current year over the last 30 days precipitated a Zacks Rank #5 for this stock. The stock lost 11.6% in the past six months.

(Check out our latest U.S. Banks Stock Outlook for a more detailed discussion on the fundamental trends.)

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