U.S. Banks Stock Outlook - April 2013 - Industry Outlook

U.S. banks entered 2013 with uninterrupted expense control, sound balance sheets, an uptick in mortgage activity and lesser credit loss provisions. Moreover, a favorable equity and asset market backdrop, falling unemployment, a progressive housing sector and a flexible monetary policy have been making the road to growth smoother.

Yet top-line growth remains uncertain due to continued sluggishness in loan growth, pressure on net interest margins from the sustained low rate environment and less flexible business models owing to stringent risk-weighted capital requirements (Basel III standard). However, banks have been gradually easing their lending standards and trending toward higher fees to dodge the pressure on the top line.

Moreover, U.S. banks are actively responding to legal and regulatory pressures, indicating competence to encounter impending challenges. But the potency of the sector is not expected to return to its pre-recession peak anytime soon. Economic intricacies, both domestic and overseas, may even result in some more disappointments in the upcoming quarters.

Overall, structural changes in the sector will continue to impair business expansion and investor confidence. Several dampening factors -- asset-quality troubles, mortgage liabilities and tighter regulations -- will decide the fate of the U.S. banks in the quarters ahead. But entering the new capital regime will ensure long-term stability and security for the industry.

Within the Zacks Industry classification, U.S. banks are broadly grouped in the Finance sector (one of 16 Zacks sectors) and are further sub-divided into six industries at the expanded level: Banks-Major Regional, Banks-Midwest, Banks-Southeast, Banks-West, Banks-Southwest and

Banks-Northeast. The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.

We rank all the 260 plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit:

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As a guideline, the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Zacks Industry Rank for Banks-Southeast and Banks-West is #60, Banks-Northeast is #84, Banks-Major Regional is #90, Banks-Southwest is #99 and Banks-Midwest is #213. Considering the Zacks Industry Rank of the six banking industries, one could safely say that the near-term outlook for the group is leaning towards 'Positive.'

Only a few banks have reported first-quarter 2013 results so far. Among these, the stupendous performances of a couple of mammoth players --

(

) and

(

) -- indicate the improved health of the sector, as these two banks command a significant portion of the U.S. banking market.

Results of these two mega banks show that top line still needs to improve for assured strength in performance. In addition to their fundamental strength, the positive developments of the sector and better macroeconomic elements helped most of the business segments of these two banks report improved results. Most importantly, similar to the last couple of quarters, these two banks did not have to majorly depend on accounting tricks to increase their earnings.

Moreover, progress seen in 2012 gives a clear growth indication. Federal Deposit Insurance Corporation (FDIC)-insured commercial banks and savings institutions earned $141.3 billion in the year, up 19.3% from 2011. This is the second-highest level since reporting earnings of $145.2 billion in 2006.

Besides contraction in provisions for credit losses and cost containment, marked recovery in the bond and equity markets and consequent revenue growth helped most of the banks report higher-than-expected earnings. Expanding consumer credit and overall improvement in lending activity made it easy for banks to show steady growth.

In the final quarter of 2012, the industry witnessed substantial improvement with the institutions reporting 36.9% year-over-year growth in earnings to $34.7 billion. This marked the 14th straight quarter of year-over-year earnings increase.

Around 60% of all institutions witnessed year-over-year improvements in net income during the quarter. Also, the share of institutions reporting loss slumped to 14.0% from 20.2% a year ago. Given the solid start by a few mega-banks, the improvement should further gain ground in the first quarter of 2013.

During the first quarter of 2013, bank failures have almost bottomed out with the failure of only 5 FDIC-insured banks. This is the lowest quarterly tally since the recession started four years ago (only 2 insured institutions failed in the second quarter of 2008). This compares with 8 bank failures in the fourth quarter of 2012.

Moreover, as of Dec 30, 2012, the number of FDIC's "problem institutions" declined from 694 to 651. As the overall sector continues to recover, the list of "problem institutions" is expected to shorten when the FDIC releases the final list for the first quarter of 2013.

We don't expect reduction in provisions for credit losses to significantly help earnings growth in the upcoming quarters as the difference between loss provisions and charge-offs is gradually decreasing.

Banks will definitely try to look at other areas -- interest income, non-interest income and operating costs -- to maintain earnings growth, but there will be limited opportunities given regulatory restrictions and sluggish economic recovery.

Efforts to cut interest expenses and take additional risks to improve net interest margins could be marred by a flattening yield curve. Further, shifting assets to longer maturities for net interest margin strength could backfire once interest rates start rising.

Conversely, increasing revenues through non-interest sources -- prepaid cards, new fees, higher minimum balance requirement on deposit accounts and pushing credit cards -- could be hampered by regulatory actions, economic volatility and soaring overhead. However, with a rebound in capital market activity, the propensity to invest in the market increased, which may lead to more non-interest revenue sources. So, non-interest income can marginally contribute to the total revenue.

Eventually, banks will have to resort to cost containment through job cuts and reduced size of operations to stay afloat. So, any cost-cutting measure will act as a defense. The last four and a half years saw over half a million banking layoffs, and the story continues.

Steady deposit growth from lack of low-risk investment opportunities post-financial turmoil is quite possible, but high charge-offs and delinquency rates plus weak demand could keep loan growth under pressure through the remainder of the year. Though banks are easing lending standards to accelerate loan growth, credit quality concerns are likely to mar the effort.

Banks are also trying to address asset-quality troubles by divesting nonperforming assets, but we don't expect balance-sheet strength to return anytime soon.

The implementation of Basel III requirements from this year will boost minimum capital standards. But adjusting liquidity management processes will cause a short-term negative impact on the financials of U.S. banks.

This will ultimately make credit costlier and reduce employment. But a greater capital cushion will help larger banks withstand internal and external shocks over the long run.

Though improved economic data such as higher consumer spending and gross domestic product (GDP), improving housing market and declining unemployment rate point towards optimism, a paltry interest-rate environment is disturbing.

The European debt crisis should exacerbate the situation. Though U.S. commercial banks appear to have significant direct and indirect exposure to Europe, potential costs are expected to be manageable. But if the crisis continues, worldwide capital markets will face a big blow, and the U.S. will not go unscathed.

Though the improving performances by banks seem already priced in and there remain significant concerns, the sector's performance in the upcoming quarters is not expected to disappoint investors.

Specific banks that we like with a Zacks Rank #1 (Strong Buy) include

(

),

(

),

(

),

(

),

(

),

(

) and

(

).

Stocks in the U.S. banking universe with a Zacks Rank #2 (Buy) currently include

(

),

(

),

(

),

(

),

(

),

(

),

(

),

(

) and

(

).

The profitability metrics (like returns on equity and return on assets) are expected to be under pressure. Further, difficulty in liquidity management due to regulatory restrictions will restrict top-line growth.

Specific banks that we don't like with a Zacks Rank #5 (Strong Sell) include

(

),

(

) and

(

).