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Industry Outlook

There are substantial reasons for bank stocks underperforming over the past few quarters. Particularly, concerns over the industry’s vulnerability to a flattening yield curve due to the low rate environment, regulatory hindrance, global growth instability, collapse of commodity prices, and the most recent Brexit aftermath kept investors away. But had there not been enough positives to counter, banks would not have delivered competitive earnings numbers. In fact, proactive actions, technical affluence, slow-and-steady loan growth, support from an improving domestic economy and many more positive factors might change the fate of banks over time.             

 

Moreover, the concerns seem overblown now and perhaps bank stocks are affected more than what was warranted by their fundamentals.

Banks have learned to take the low-rate environment in stride and have earned significant fundamental strength by reorganizing their business models. Moreover, while global economic uncertainty – which has been fueled by Britain's vote to leave the European Union (Brexit) – is weighing on the prospect of a rate hike any time soon, it might not demotivate the Fed for long to tighten the monitory policy to the extent it wants. While the global economy might take a decent time to show resilience, the ongoing improvement in the domestic economy might prove convincing for the Fed.    

At least, the backdrop is not as bad as is needed to keep the rates low for a very long period. Therefore, U.S. banks will undoubtedly get a boost from a rising rate cycle. This, along with the strength in core business earned by passing through dragged out regulatory scanners, should help them reach the turning point of consistent growth before long.

Though the earnings performance over the last few years has failed to garner investors’ confidence, the results depict banks’ efforts in pairing up aggressive actions (like creating new revenue sources) with defensive measures (like expense control) to tide over persistent challenges. Moreover, banks have earned the ability to deal with crises, as evident by the passing of the Fed’s stress test by all 33 banks last month. They can now dodge pressures from the operating environment more easily.

Moreover, banks are trying to reorganize risk management practices to address potential solvency issues from rising interest rates. Asset-quality troubles are also being addressed by divesting segments containing nonperforming assets.

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

Loan Growth: A Bright Spot

Demand for loans is on the rise with recovering economic conditions and easier lending standards. Both business loans and residential mortgages have increased significantly in recent years. Further, the speculation of a higher-rate environment any time soon has driven borrowers to apply for loans well ahead of time, leading to increased demand. 

FDIC’s "Problem List" Shortens
 
The first quarter of 2016 marked the 20th straight quarter of decline in the FDIC's "Problem List." The list contained 165 names as of Mar 31, 2016, down from 183 as of Dec 31, 2015. In fact, this is the lowest level since the end of 2008 and represents an over 80% decline from the post-crisis high of 888 as of Mar 31, 2011.

This undoubtedly reflects improvement, but the number is still high considering the occurrence of the financial crisis nearly eight 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 a lot lower by now. This indicates that the industry is still hassled.

The number of bank failures has nonetheless declined every year since 2010. There have been just three bank failures so far in 2016 compared with 8 failures in 2015 (versus 18 in 2014, 24 in 2013, 51 in 2012, 92 in 2011 and 157 in 2010). Though the pace of bank failures has been decelerating, the industry is yet to see an average failure of just four or five banks annually, which would indicate maximum strength.

Liquidity Standards Strengthens Thanks to Regulations

Regulatory changes, in particular the 2010 Dodd-Frank law, made systematically important banks self-sufficient (in terms of capital reserves) to some extent, to endure any further crises. So the likelihood of a bailout is now reduced.

Last year, a proposal by the Fed required the large banks to add another buffer to make them more capable of dealing with future crises and correct their "too big to fail" perception. In order to meet the requirements, six of the eight key U.S. banks would need to raise $120 billion, per Fed officials.

Further, a new set of rules put forth by the Financial Stability Board (“FSB”), which was created by the Group of 20 nations to keep banks’ reckless behavior at check, would make the "too big to fail" notion a thing of the past. The draft rules of the FSB require banks to maintain a loss-absorbing capacity ratio (capital plus senior debt/total risk-weighted assets) of at least 16% to 20%. This would act as a buffer should any of these banks run the risk of failure.
   
Though the biggest banks will continue to enjoy low borrowing costs and take bigger risks until these rules are effective, the advantages should wane with time. This will actually make the competitive landscape better for small and mid-cap banks.

Enhanced Focus on Competitive Advantage

Along with the adoption of advanced technologies to enhance cyber security, banks are resorting to increased use of analytics to drive efficiency. This could help them to better formulate strategies and enhance the top line of different business segments.

While analytics can elevate their expenses in the quarters ahead, concerted efforts to cut needless expenses should more than offset it.

Buying Opportunity

Since there are plenty of positive drivers amid broader concerns, one can consider buying some beaten down bank stocks that promise better performance in the long run. Picking those with a favorable Zacks Rank is an easy and effective way.

Specific banks that we like with a Zacks Rank #1 (Strong Buy) include Southside Bancshares, Inc. (SBSI), Southwest Bancorp, Inc. (OKSB - Free Report) , First Midwest Bancorp Inc. (FMBI), and Access National Corp. (ANCX - Free Report) .
 
Stocks in our U.S. banking universe with a Zacks Rank #2 (Buy) currently include Comerica Inc. (CMA - Free Report) , BancFirst Corp. (BANF - Free Report) , Heartland Financial (HTLF - Free Report) , and First Horizon National Corp. (FHN - Free Report) .

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