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What Spells Trouble Ahead for U.S. Banks?

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The market is no longer aggressively speculating the benefits of banks from a rising rate environment, as the Fed rate hike is likely to stay off the table for the remainder of 2016. If concerns over global economic growth and unsatisfactory domestic factors weren’t enough, the Brexit storm added to the reasons for the already-dovish Federal Reserve staying away from hiking rates any time soon. Quite naturally, it leaves little room for improvement in banks’ net interest margins – the difference between deposit rates and lending rates.         

This coupled with the other nagging factors – including exposure to the distressed energy sector, collapse of commodity prices, global economic threats and the latest Brexit fallout – will likely keep the prospects of U.S. banks gloomy.

Though oil prices showed recovery in the past quarter, banks will have to set aside money to cover the potential loss from their energy debt until either the energy sector stabilizes or they reduce their energy exposure. And this could keep curbing their earnings.

Further, the earnings performance of U.S. banks was not discouraging in the past few quarters. But this was mainly attributable to the temporary defensive measures that they adopted to tide over the legacy as well as new challenges.

Along with strong growth in loans, banks’ proactive actions to move beyond defensive actions like cost containment to offset the pressure on interest income by enhancing alternative revenue sources have supported results for the last few quarters. Yet, these are not enough to encourage investors as evident by the lackluster performance of the bank stocks. This is because, burning issues like cybercrime and unconventional competition have piled up on existing concerns to keep the overall picture dreary.

Though recovering economic conditions and easier lending standards should continue to expedite loan growth, the benefits may not be realized any time soon. Added to these are the inconsistent performance by the key business segments and dismal top-line growth.
Banks are trying every means to contain costs, either by closing lackluster operations or by laying off personnel. Yet nonstop legal expenses plus higher spending on cyber security, analytics and alternative business opportunities are costing a pretty penny.

In an earlier piece (U.S. Banks Hold Good Prospects for Long-Term Investors), we provided arguments in favor of investing in the U.S. banks’ space. But here we would like to argue the opposite case.

Dealing with Future Losses Could Prove Tough

U.S. 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, the capital buffers that U.S. banks are forced to maintain might not be enough to fight the risks of a default.

Also, if the energy sector witnesses any further collapse, banks will have to build up more cash reserves to cover their losses from energy loans. This will have a significant impact on their earnings. On the other hand, prohibiting drillers from their loan portfolio could end up doing more damage, as it will reduce the chance of repayment of the money that they have already lent.  
Non Rate-Sensitive Revenues Yet to Be Dependable

Banks’ strategies to focus more on non-interest revenue sources for strengthening their top line have not been smooth sailing. 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 the greater propensity to invest in alternative revenue sources on the back of an improved employment scenario might result in higher non-interest revenues, grabbing good opportunities will require a higher overhead.

A Rate Hike in the Long Run Might Not Be a Big Help

If the rates rise at all in the long run, banks will benefit only if the increase in long-term rates is 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). This opposite case will 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 that they gathered 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 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 of the same from loans.

On the other hand, credit quality -- an important performance indicator for banks -- should improve with the interest rate hike. But the prolonged low interest rate environment has forced banks to ease underwriting standards for long. This, in turn, has increased the chance of higher credit costs for quite some time.

Deteriorating Quality of Earnings Could Be Damaging  
Banks have been delivering better-than-expected earnings for quite some time now, but the surprises have mostly been helped by conservative estimates. Promising low and then impressing the market with an earnings beat is the trend.

Also, the way of generating earnings seems a stopgap. Measures like forceful cost reduction and lowering provision may not last long as earnings drivers. Further, continued narrowing of the gap between loss provisions and charge-offs will not allow banks to support the bottom line by lowering provision.

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.

Stocks to Dump Now

There are a number of reasons to worry about the industry’s performance in the short 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.

We suggest dumping BankUnited (BKU), M&T Bank Corporation (MTB - Free Report) , KeyCorp (KEY - Free Report) and Webster Financial Corporation (WBS - Free Report) as they carry a Zacks Rank #5 (Strong Sell).

We also suggest to stay away from stocks with a Zacks Rank #4 (Sell) including Bank of New York Mellon Corp (BK - Free Report) , Wells Fargo & Co (WFC - Free Report) , Westamerica Bancorporation and BofI Holding, Inc. (BOFI - Free Report) .  

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

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