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Foreign Banks Stock Outlook - June 2016

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A weakening global economy, slowdown in investment following oil price doldrums, persistently low interest rates and geopolitical uncertainty have been taking a toll on a majority of foreign banks, hurting their recovery for quite some time now. And if these were not enough, banks in emerging markets recently also bore the brunt of China’s slowdown, the downswing in commodity prices, the U.S. Federal Reserve’s move to tighten its monetary policy and declining capital flows.

However, the worst is possibly over for banks in the developed nations, given the efforts they put in the face of challenges by realigning their operations and a recovery of their economies. European banks in particular have shown significant progress in reducing the overhang of bad loans.

The latest global growth forecast for 2016 by the International Monetary Fund (IMF), however, doesn’t look favorable for the overall banking sector. The fund revised down its forecast for this year by 0.2 percentage points in April 2016. Slower growth might hold back the recovery of foreign banks that are yet to build capital buffers like the large U.S. banks.

Banks in emerging markets will continue to suffer as their economies are witnessing declining capital inflow. A further increase in interest rates in the U.S. will make matters even worse for these economies and their banks. Making the picture murkier is IMF’s discouraging expectations from countries like Russia and Brazil that are already facing a recession.      

However, the IMF revised China’s growth forecast by 0.2 percentage points upward to 6.5%, as the country’s manufacturing downturn was offset by growth in its service sector. This indicates lesser global economic pressure related to China – which could be a big relief for banks across the globe.

Further, banks will continue to improve solvency and balance sheet liquidity as they move closer to comply with the Basel III requirements. However, continued weakness in profitability and evolving regulatory strictness will restrict any significant improvement in the short to medium term.          

No such improvement is expected on the interest rates front, either. The developed nations (except the U.S., which has started to raise interest rates) – in particular Europe and Japan – are expected to keep monetary policy loose for a longer stretch to support their economies. And, as we know, it’s difficult for banks to thrive in a low interest rate environment.   
Also, an expected resumption of rate hike in the U.S. will have the potential to disrupt other economies, primarily by making borrowing costlier for them. Actually, money from these economies will move to the U.S. for the benefit of higher rates. And a strengthening dollar will make loan repayment expensive for these economies.  
How Banks Are Exposed to the Macro Backdrop

While growth driven by low oil prices will definitely support global banks with business gains, a low interest rate environment as a result of loose monetary policy will continue to mar the rate-sensitive portion of their revenues.

On the other hand, any action to lower interest rates in emerging markets that have a tight monetary policy and high inflation (like Brazil) could heighten inflation issues. This, in turn, would take a toll on their banks.

Further, a rising rate environment in the U.S. would lead to a capital flight from emerging markets. This would dry up the liquidity of banks in these regions.  

These aside, the ever-increasing regulatory restrictions triggered by continued wrongdoings by banks to counter economic pressure might soften the industry’s upturn.
Overall, the weakness in the global financial system is likely to keep the backdrop cluttered for foreign banks.
Business Realignment May Not Be a Saving Grace

Foreign banks keep repositioning business fundamentals to protect themselves against further crises. Defensive actions like limiting expenses by contracting operations and retrenching workforce are still in place, and the focus on noninterest income is deepening. But sluggish business activity due to economic disorder, margin compression and slothful loan growth remain serious dampeners.

Capital efficiency remains the key to survival, and most foreign banks have been strengthening their capital ratios by selling non-core assets for quite some time. While this will make their businesses safer, growth prospects appear bleak with thinning sources of income.

Continued Pressure on Revenues

The interest rate environment in developed nations (except the U.S.) is not expected to revive any time soon. Naturally, interest-sensitive revenues for banks in these regions are likely remain under pressure. At the same time, their non-interest revenue sources will be limited by regulatory restrictions.

Banks in consumption-driven economies, however, may not be significantly challenged by interest income due to a not-too-low interest rate environment which is needed to keep inflation in check. However, these banks will have no respite from the nagging non-interest revenue challenges. Further, the expected capital outflows from these economies with rising interest rates in the U.S. will add to their woes. Also, intense competition from domestic and foreign players will continue to hinder revenue generation.

Evolving Issues

FinTech Posing Threat to Banks: The emergence of financial technology companies (known as FinTech), which offer an array of financial services through mobile and cloud computing, is a significant threat to banks. Experts predict growth of FinTech to make traditional branch-based banks redundant in the next 10 years.
Cyber-Crime to Increasingly Hurt Banks: As banks are gradually becoming more technology dependent to suit the changing mindset of the new generation with respect to money, the threats of cyber-crime are increasing.

What to Expect on the Regulatory Front?

The impact of tighter regulations is yet to be fully felt, with many rules pending implementation across jurisdictions. Continued attempts on strict capital standards by regulators worldwide to clip the risk-taking attitude of banks and prevent the recurrence of a global financial crisis will restrain the potential of industry players far and wide.

The final rules (issued on Nov 9, 2015) of the Financial Stability Board, which was created by the Group of 20 nations (G-20) to keep banks’ reckless behavior in check, require 30 global systematically important banks – that the Basel Committee believes are at risk of turning to too big to fail – to maintain a loss-absorbing capacity ratio (capital plus senior debt/total risk-weighted assets) of at least 16% from Jan 1, 2019. The requirement will increase to at least 18% from Jan 1, 2022. It’s quite likely that these banks will have to issue new debt to meet these requirements.      

Further, the full implementation of the Basel III standards – the risk-proof capital standard agreed upon by regulators across the globe – is due in 2019. The primary requirement for banks is to maintain a minimum total capital ratio of 10.5% by 2019. Though the majority of foreign banks have made significant progress in meeting new liquidity rules, they have yet to fully comply with the standards. So the pressure on capital structure will continue for some time and banks will be less flexible in terms of business investments.

In addition to maintaining higher capital levels, global banks might see some new regulations down the road, given the proactive approach of regulators in seeking ways to keep a check on arbitration, overdraft and debt collection issues.

Bottom Line

While the rate-hike stance of the Fed is posing near-term concerns over funding insufficiency in the other economies, the not-so-effective cost-control measures and limited access to revenue sources will restrict bottom-line improvement of foreign banks in the upcoming quarters.

Of course, cost reduction by job cuts and asset sales have been instrumental keeping foreign banks afloat, but these strategies may no longer be enough. Instead, the aim should be to enhance operational efficiency through fundamental changes in business models.
However, it’s not easy to deal with an unfavorable macro backdrop. So it’s actually time to play defensive and modify products to meet evolving customer preferences.

Foreign Banks to Dump Now

Given the concerns surrounding the foreign banking space, it would be prudent to stay away from industry players that have not been able to win analysts’ confidence with their activities. The following stocks have been witnessing downward estimate revisions and thus carry an unfavorable Zacks Rank:

Currently, Zacks Rank #5 (Strong Sell) stocks are BBVA Banco Francés S.A.BFR, Deutsche Bank AG (DB - Free Report) and UBS Group AG (UBS - Free Report) .

Zacks Rank #4 (Sell) stocks include Credit Suisse Group AG (CS - Free Report) , HSBC Holdings plc (HSBC - Free Report) and National Australia Bank Limited (NABZY - Free Report) .

Investment Opportunities

The industry might not be able to tide over the economic mayhem anytime soon, but this is perhaps the right time for long-term investors to build positions in foreign bank stocks that have the best prospects and look cheap now. Here are a few stocks that have been witnessing positive estimate revisions and carry a favorable Zacks Rank:

Currently, Zacks Rank #1 (Strong Buy) stocks include Royal Bank of Canada (RY - Free Report) and Shinhan Financial Group Company Limited .

We also recommend Zacks Rank #2 (Buy) stocks including The Toronto-Dominion Bank (TD - Free Report) , Canadian Imperial Bank of Commerce (CM - Free Report) and Barclays PLC (BCS - Free Report) .

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