U.S. Banks Stay Afloat - Cutting Costs or Core Business? - Zacks Analyst Interviews

U.S. banks showed some resilience in the recently reported second-quarter results after a gloomy start to the year in a tough industry backdrop. Weakness in capital market business and sluggish mortgage banking activities prevailed but cost containment and modest improvement in core businesses paired up to counter the pressure. This still wasn't enough to report numbers better than the year-ago quarter but thanks to conservative estimates, banks delivered positive earnings surprises.   

Looking at core businesses, though mortgage portfolios continued to decline and pressure on net interest margin prevailed, the quarter witnessed decent loan growth on the back of improvement in commercial, industrial and auto categories. Also, the heightened M&A and IPO activities led to solid investment banking business.

Legal costs, which have now become part of bank financials, did not calm down during the quarter. In fact, these still remained acute in the Q2 financials of a few banks. Notably, Bank of America Corporation (BAC) revealed huge litigation expenses in its latest report. With increasing regulatory scrutiny on the business model, banks are not expected to get rid of such expenses at least in the near term.        

Overall, U.S. banks are having a rough time. Along with softness in some business segments, too many mandatory defensive measures are thwarting growth. With a dearth of significant loan growth (primarily in the mortgage segment) and pressure on net interest margins from a nagging low rate environment, top-line growth remains uncertain.

However, banks have been trending toward higher fees to dodge top line pressure. Easing lending standards to some extent after complying with regulatory guidelines has also become a trend. Along with these efforts, continued expense control and balance sheet restoration should act as tailwinds in the upcoming quarters. Further, a favorable equity and asset market backdrop, and supportive macroeconomic factors – such as falling unemployment, a progressive housing sector and flexible monetary policy – should pave way for stability.

Interest rate spreads are unlikely to support top line soon as the Fed intends to keep interest rates low for a considerable time.  On the other hand, along with continued decline in revenues from mortgage fees, softness in the trading side of the business should keep a lid on top line.    

We don't see this issue-ridden sector returning to its pre-recession peak anytime soon. What encourages us though is that the U.S. banks are getting accustomed to increased legal and regulatory pressure and resorting to safer alternatives for higher returns. But structural changes in the sector will continue to impair business expansion and investor confidence for some time.

Zacks Industry Rank

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-West, Banks-Northeast, Banks-Southeast and Banks-Southwest. 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: About Zacks Industry Rank)

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-Southwest is #30, Banks-West is #37, Banks-Midwest is #87, Banks-Northeast is #94, Banks-Southeast is #104 and Banks-Major Regional is #105. Considering the Zacks Industry Rank of the six banking industries, one could safely say that the outlook for the group is ‘Neutral' to 'Positive.'

Earnings Trend of the Broad Sector

All companies in the ‘Banks-Major' and ‘Banks & Thrifts' industries, which are the medium-level (or M-level) components of the broader Finance sector, have reported Q2 results. For ‘Banks-Major', the earnings beat ratio (percentage of companies coming out with positive surprises) was 86.7%, while the revenue beat ratio was 93.3%. The picture for ‘Banks & Thrifts' however wasn't that strong – earnings and revenue beat ratios were 80% and 60%, respectively.

So far, 83.8% companies in the broader Finance sector have reported Q2 results with earnings and revenue beat ratios coming in at 79.1% and 77.6%, respectively. The sector has witnessed a year-over-year earnings increase of 0.3% on 0.4% revenue growth so far. This compares favorably with prior quarter's earnings and revenue declines of 5.8% and 2.3%, respectively.   

Banks-Major witnessed an earnings decline of 2.7% compared with a decline of 13.6% in Q1. Banks & Thrifts however witnessed an earnings improvement of 8.9% compared with a decline of 6.6% in Q1. On the revenue front, Banks-Major experienced a 3.9% decline versus 5% decline in Q1. Banks & Thrifts also showed a revenue decline of 1.8% compared with 3.2% decline in the prior quarter.      

The broader Finance sector's consensus earnings expectations for Q3 and full-year 2014, however, look better with 4.8% and 2.5% year-over-year growth rates, respectively.

For a detailed look at the earnings outlook for this sector and others, please read our Earnings Trends report.

‘Too-Big-To-Fail' Advantage Wanes, But Exists

Mega banks have been continuously benefiting from lower funding and operating costs since the financial crisis six years ago. This is because of the impression that Federal Reserve will always protect these banks from failing in case of any major financial trouble. However, the advantages have been waning in recent years.

A recent study by the Government Accountability Office found that the market advantage for these banks declined in 2013. The regulatory changes, particularly the 2010 Dodd-Frank law, made these systematically important banks self-sufficient (in terms of capital reserves) to some extent to endure any further crisis. So the likelihood of a bailout requirement is less now.

But the biggest banks still enjoy low borrowing costs and take bigger risks than smaller players because of the U.S. government's ‘too-big-to-fail' impression, as per study by the Federal Reserve economists in March. The study revealed that the five largest banks have enjoyed a statistically significant 0.31% funding advantage over their smaller peers since 2009. Further, according to a March report by the International Monetary Fund, the ‘too-big-to-fail' tag helped these banks save $70 billion in funding costs in 2012.

We believe this malformed notion will continue to keep these banks at an advantageous position, though less than before, for some time.
 
Does ‘Problem Bank List' Indicate Any Good?

The FDIC's ‘Problem List' contained 411 names as of Mar 31, 2014, down from 467 as of Dec 31, 2013 and 884 (the highest number since the financial crisis started) as of Dec 31, 2010. While this is no doubt an improvement, the numbers look extremely high considering the financial crisis six 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 much less. This indicates that the industry is still fraught with trouble.

However, 12 banks failed during first half of 2014 compared with 16 failures in the same period last year. Total 23 banks failed in 2013 (versus 51 in 2012 and 92 in 2011) and a lesser number is expected in 2014. Though the pace of bank failures has been declining, the industry is still to see an average failure of just four or five banks annually, which would indicate maximum strength in the industry.

Growth Path Remains Bumpy

Continued narrowing of the gap between loss provisions and charge-offs will not allow contracted provision to significantly drive earnings in the upcoming quarters. So banks are trying to look at other areas – primarily non-interest income and operating costs. While cost reduction through reorganizing operations and job cuts will support bottom line, opportunities for generating non-interest revenues – from sources like charges on deposits, prepaid cards, new fees and higher minimum balance requirement on deposit accounts – would be curbed by regulatory restrictions and still shaky economic recovery.

Efforts to cut interest expenses and take additional risks to improve net interest margins could be marred by a still-flat yield curve. Further, shifting assets to longer maturities for strengthening net interest margin could backfire if the Fed decides to increase interest rates in the near to midterm.

The persistent low-interest-rate environment has a mixed impact on banks. While it reduced their borrowing costs, limitation to charge high interest on loans marred revenues. When interest rates finally start rising, benefits of banks will depend on their ability to charge more for loans than what is paid on deposits.

However, increasing propensity to invest in the market on the back of an improved employment scenario may create more non-interest revenue sources. Grabbing these opportunities will require higher overhead, so cost management needs to be more efficient to realize some benefit.

As a key strategy, banks will have to resort to cost containment, but it would act only as defense and not a concrete way to lessen top-line pressure. The industry witnessed more than half a million layoffs over the last five years just to stay afloat, and the story will continue.

Balance Sheet Recovery Continues   

Steady deposit growth from lack of low-risk investment opportunities is quite possible. Also, demand for loans has been increasing with the recovering economic condition and relatively easy lending standards. But banks have still been witnessing high charge-offs and delinquency rates that could limit loan growth.

Moreover, though growth in gross domestic product (GDP) and reducing unemployment will help banks strengthen their balance sheets, reversal of interest rate environment will result in unrealized losses on underlying securities.

However, banks are trying to reorganize risk management practices to address potential solvency issues from rising interest rates. Efforts are also being given to address asset-quality troubles by divesting nonperforming assets. Yet, we don't expect balance-sheet strength to return to pre-recession peak any time soon.

OPPORTUNITIES

The expected near-term sluggishness in the industry and downbeat guidance from a number of industry participants seem to have started pricing in. So one may consider buying some bank stocks that promise better performance based on their strong fundamentals.

Specific banks that we like with a Zacks Rank #1 (Strong Buy) include Banc of California, Inc. (BANC), Bank of the Ozarks, Inc. (OZRK), Farmers Capital Bank Corporation (FFKT), First Community Bancshares, Inc. (FCBC), United Financial Bancorp, Inc. (UBNK), Farmers and Merchants Bancorp Inc. (FMAO), MidWest One Financial Group, Inc. (MOFG) and Central Valley Community Bancorp (CVCY).

Stocks in the U.S. banking universe with a Zacks Rank #2 (Buy) currently include BOK Financial Corporation (BOKF), Cullen/Frost Bankers, Inc. (CFR), Community Trust Bancorp Inc. (CTBI), Fidelity Southern Corporation (LION), Arrow Financial Corporation (AROW), Community Bank System Inc. (CBU), Horizon Bancorp (HBNC), Huntington Bancshares Incorporated (HBAN) and City National Corporation (CYN).

WEAKNESSES

Difficulty in liquidity management due to regulatory restrictions will continue to restrict top-line growth of banks in the quarters ahead.

Specific banks that we don't recommend with a Zacks Rank #5 (Strong Sell) are DNB Financial Corp. (DNBF), First NBC Bank Holding Company (NBCB), The Community Financial Corp. (TCFC), Fulton Financial Corporation (FULT), Old Line Bancshares Inc. (OLBK), Tristate Capital Holdings, Inc. (TSC), FirstMerit Corporation (FMER) and First Republic Bank (FRC). We also don't recommend a few Zacks Rank #4 (Sell) banks including Texas Capital BancShares Inc. (TCBI), BancorpSouth, Inc. (BXS), First Bancorp (FBP), CenterState Banks, Inc. (CSFL) and TriCo Bancshares (TCBK).