Non-U.S. banks have shown improvement to some extent so far in 2013, thanks to the defensive and proactive steps by the central banks of most developed and emerging economies. However, the global financial system must gain strength to signal an upward trend.
With policy makers still struggling to avoid further collapse, a flurry of banking regulations can be felt throughout the world. This is, however, taking a toll on banks’ top and bottom lines. As a result, banks all over the world are seeking new strategies to lessen the regulatory burden in order to plan the path to future growth.
With capital efficiency being the key focus, most foreign banks are adopting reconstruction-by-asset-sale strategies to strengthen capital ratios. So the prospects for the remainder of 2013 look better but not impressive as the sector must continue to fight macroeconomic challenges which could keep growth muted.
Moreover, a prolonged low interest rate environment is not expected to reverse any time soon as central banks of most of the countries will continue to prioritize growth over inflation control. This strategy is sustainable as inflation is the concern of only a few emerging economies.
Thus, banks operating in a low interest rate environment will not be able boost revenue through interest income. On the other hand, non-interest revenue sources will be limited by regulatory restrictions.
Banks in consumption-driven economies will not, however, face significant challenges related to interest income due to a not-too-low interest rate environment. Still-high inflation will continue to force the central banks of these economies to keep interest rates higher than the low-inflation economies. However, non-interest revenue challenges will persist for these banks as well.
Most of the major non-U.S. banks do not mind complying with stringent regulation, but it would make the optimization of business investments difficult for them. So banks will need to reassess and restructure their operating models to improve their financials, which will take considerable time.
The Recent Past
Despite the ongoing macroeconomic and regulatory challenges, the majority of the world’s largest banks showed impressive results in the first quarter of 2013. Among others, giants like UBS AG (UBS), Barclays PLC (BCS - Free Report) and HSBC Holdings plc (HBC) ended the quarter with improved earnings. Most of the banks witnessed strong capital ratios and improved credit quality. The betterment was also reflected in the share price performance of these banks in the last few months. The MSCI World Bank Index has appreciated around 20% over the last one year.
However, a risk-aversion tendency has kept client activity restrained, resulting in weak trading volumes and subdued loan demand. Also, learning from past experience, banks are now more cautious about lending money.
But thanks to worldwide regulatory reform, the sector has at least entered into a transformation phase with the restructuring efforts in place. Needless to mention, an essence of growth is yet to be felt.
What to Expect Moving Forward?
Growing challenges related to funding, still-high costs despite belt-tightening through layoffs and other measures, and limited access to revenue sources will keep bottom-line improvement under pressure in the upcoming quarters.
The growth potential of some non-U.S. banks could also be restrained by higher reserve requirements and outsized losses related to capital markets. Consequently, valuation multiples of these banks will continue to reflect the fundamental challenges at least through the remainder of 2013.
Moreover, regulatory pressure to focus more on the home market is forcing these banking giants to hold back international expansion and sell existing assets in other countries. This will ruin the efforts to restructure their operating models and meet long-term funding needs.
Nonetheless, strict lending limits as well as greater transparency in regulations could strengthen the fundamentals of many sector participants. Eventually, these are expected to create a less risky lane for the overall industry.
The Persistent Challenges
The key trouble for non-U.S. banks is regulatory pressure, which ensued from taxpayers' money and government intervention that were required for them to remain in business. The impact of regulations is yet to be fully felt with many rules still impending.
Additionally, government efforts to alleviate industry concerns have significantly raised political debates over time. Politics will continue to influence lending decisions as long as banks 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 need for government backing is still felt acutely by the European banks.
Adding to the concern is the tendency of regulators worldwide to agree on strict capital standards to clip the risk-taking attitude of banks to prevent the recurrence of a global financial crisis. The introduction of Basel III standards is a case in point.
While the full implementation of the required capital levels under Basel III is due in 2018, many banks have already started complying with the requirements to fix their damaged reputation following a number of high-profile scandals in the industry. To make matters worse, the latest changes indicate that banks need to hold more capital compared to what the Basel Committee mandated initially.
With these regulatory measures, the capital structure of banks will remain under constant pressure, though this would eventually make their balance sheets more recession-proof.
Valuations Look Attractive
Ongoing balance sheet repair and credit environment recovery will make the valuations of most of the non-U.S. bank stocks less expensive going forward. However, the mega banks, which can comfortably maintain the minimum capital norms mandated by the Basel Committee, will experience the fastest valuation upside. Consequently, we believe this would be a good time for long-term investors to add foreign bank stocks to their investment kitty.
Investors with short-term targets, however, should be watchful while choosing foreign bank stocks at this point as near-term fundamentals do not look promising. Asset quality lacks the potential to a 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 and a low interest rate environment in most of the countries.
If any improvement occurs in the near-to-mid term, it will vary from country to country, depending on industry circumstances.
Mixed Rating Actions
Rating downgrades remained a major threat for global banks in 2012, but 2013 started off with better response from a few rating agencies on a few banks. Banks that showed improvement in liquidity, funding and capitalization earned positive rating actions.
In May 2013, Fitch Ratings affirmed its credit ratings on 12 global banks including non-U.S. banks like Barclays, Credit Suisse (CS - Free Report) , BNP Paribas S.A. (BNPQY), Deutsche Bank AG (DB - Free Report) and HSBC. The rating agency accounted for the solid progress made by banks to meet their regulatory capital ratio requirements.
However, in Jun 2013, Standard and Poor’s (S&P) reduced its credit ratings on 15 big global banks including Barclays, HSBC, Royal Bank of Scotland Group Plc. (RBS - Free Report) and UBS AG. A sweeping overhaul of the agency’s ratings criteria resulted in these downgrades. Earlier, in Mar 2013, the rating agency put Deutsche Bank's long-term credit rating on negative watch following weak 2012 results.
According to Moody's Investors Service, the rating arm of Moody's Corp. (MCO - Free Report) , the ratings of global banks are expected to be relatively stable in 2013. The rating agency will keep an eye on excessive risk-taking by banks to offset the negative effects of low interest rates and regulatory reforms.
Overall, the industry may witness more positive rating actions if banks can evade the lingering macroeconomic issues with their smartened up business models.
Eurozone Concerns Easing
Eurozone woes should not be a major challenge for global banks anymore as the downside risk of the European economy appears to be less than what it was a year ago. The economy is showing improvement with sharp growth in consumer confidence, streamlined business activities in the private sector and mended manufacturing. Consequently, the banking industry in the continent has recovered to some extent.
The steps taken by European policymakers have significantly helped in stabilizing the economy. Primarily, the European Central Bank’s (ECB) long-term refinancing operations have helped in injecting liquidity into the system. Further, the setting up of a banking union will allow the ECB to intervene directly in banking operations within the continent.
However, with muted growth in the economy, the banking system will continue to face challenges. Banks’ will continue to face capital pressure until the remaining issues are addressed.
Emerging Markets Look Promising
Coming to the 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 subdued capital raising.
Moreover, banks in the emerging markets generally tend to be well capitalized, less exposed to property markets, and generate steady interest income from operating in a not-too-low interest rate environment.
Overall, a key determinant for a 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 performances of non-U.S. banks.
Also, only cost reduction by job cuts and asset sales should no longer be considered enough. Instead, the aim should be to enhance operational efficiency through fundamental changes in business models. The capital goal of global banks should be more than just complying with regulatory requirements.
On the other hand, the primary attention of policymakers should be on determining the span of fiscal stimulus, ensuring that it remains till a clear sign of transition from recovery to growth is visible.
Among the non-U.S. banks, we recommend Mitsubishi UFJ Financial Group, Inc. (MTU - Free Report) and Sumitomo Mitsui Financial Group Inc. (SMFG - Free Report) that have a Zacks Rank #1 (Strong Buy).
We also like banks with a Zacks Rank #2 (Buy) including Banco de Chile (BCH), Erste Group Bank AG (EBKDY), Industrial and Commercial Bank of China Limited (IDCBY), Lloyds Banking Group plc (LYG) and Mizuho Financial Group, Inc. (MFG).
We would suggest avoiding banks that have participated in government recapitalization programs and are yet to repay. In return of government capital and asset quality protection, these banks are facing regulatory intervention, like enforcing limits on dividend payouts and board member nominations.
Currently, a couple of banks we dislike with a Zacks Rank #5 (Strong Sell) are Australia & New Zealand Banking Group Limited (ANZBY) and National Australia Bank Limited (NABZY).
We also dislike some stocks in the non-U.S. bank universe with the Zacks Rank #4 (Sell), including The Toronto-Dominion Bank (TD), Banco Santander, S.A. (SAN), Bancolombia S.A. (CIB), Bank of Montreal (BMO), The Bank of Nova Scotia (BNS) and ICICI Bank Ltd. (IBN).