After spending a number of years under strict post-crisis regulations, banks may finally get some relief in the Trump Era. President-elect Donald Trump believes that the time is ripe for dismantling the Dodd-Frank Act that has been crippling banks’ ability to run profitably since the economy came out of recession. This along with his likely pro-interest-rate-hike approach has convinced investors to bet big on bank stocks lately.
However, it’s too early to predict the benefits that banks might draw. In fact, there is ambiguity over Trump’s ability to execute structural bank changes under a Republican government. For example, Trump has called for a modern-day Glass-Steagall Act that requires separating commercial banking from investment banking. This approach is not in line with what Republicans recommend.
Further, softer regulations might benefit banks earnings mostly from domestic operations. However, larger banks with significant international exposure might lose competitiveness due to ever-increasing international regulatory standards. On the other hand, meeting international standards will restrict them from generating domestic revenues.
Actually, the Trump presidency would benefit banks if his strategies propel GDP growth. And the key drivers could be increased infrastructure spending and reduced taxes. These would lead to increased inflation pressure and accelerate rate hikes.
So investors looking for benefits of banks from the new administration may have to wait awhile.
For now, concerns over global economic growth and political uncertainly may hold the Federal Reserve back from hiking rates, leaving little room for improvement in banks’ net interest margins – the difference between deposit rates and lending rates.
Other nagging factors – including exposure to the still-struggling energy sector, continued commodity price recession and global economic growth concerns – are also likely to keep the prospects of U.S. banks gloomy.
Though oil prices have shown some recovery in the last few months, 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, while the earnings performance of U.S. banks was not discouraging in the past few quarters, this was mainly attributable to the temporary defensive measures that they adopted to tide over legacy as well as new challenges.
Along with a decent growth in loans, banks’ proactive methods to move beyond defensive actions – like cost containment to offset the pressure on interest income by enhancing alternative revenue sources – have supported results over the last few quarters. Yet these are not enough to make the growth path steady. 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 right away. Added to these are the inconsistent performance by 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 issues plus higher spending on cyber security, analytics and alternative business opportunities are costing a pretty penny.
In an earlier piece (Will Pro-Growth Trump Admin Support Banks’ Growth?), we provided arguments in favor of investing in the U.S. banks’ space. But here we would like to discuss the opposite case.
Absorbing Future Losses May Not Be Easy
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, capital buffers that U.S. banks are forced to maintain might not be enough to fight the risks of a default. Lesser restriction on capital under the Trump administration would make dealing with a default even more difficult.
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 earnings. On the other hand, prohibiting drillers from their loan portfolio could end up doing more damage, as it would reduce the chance of repayment of the moneys they have already lent.
Non Interest Revenues Yet to Be Steady
Banks’ strategies to generate more revenues from non-interest sources are working well, but the sources are not yet dependable. 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.
Higher Interest Rates May Not Turn the Tide
When rates rise, 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 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 from loans.
On the other hand, credit quality -- an important performance indicator for banks -- should improve with an interest rate hike. But the prolonged low interest rate environment has forced banks to ease underwriting standards. This, in turn, has increased the chance of higher credit costs.
Quality of Earnings Trending Down
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 name of the game.
Also, the way of generating earnings seems a stopgap. Measures like forceful cost reduction and lowering provisions 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 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.
Stocks to Dump Now
Despite the expected benefits under the new government, 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:
Franklin Financial Network, Inc. (FSB - Free Report) :This Zacks Rank #5 (Strong Sell) stock has gained about 18% since the beginning of the year, compared with nearly 26% gain for the Zacks categorized Banks and Thrifts industry. The stock’s earnings estimates for the current fiscal year have been revised 4.7% downward over the last 60 days.
First Business Financial Services, Inc. (FBIZ - Free Report) :A 16.2% downward revision in earnings estimates for the current fiscal year over the last 30 days precipitated a Zacks Rank #5 for this stock. The price of this stock has declined over 12.3% since the beginning of the year.
First NBC Bank Holding Company (FNBC - Free Report) : This Zacks Rank #5 stock has lost over 80% since the beginning of the year, compared with about 5.8% gain for the S&P 500. The stock’s earnings estimates for the current fiscal year have been revised 12.1% downward over the last 60 days.
(Check out our latest U.S. Banks Stock Outlook for a more detailed discussion on the fundamental trends.)
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