Bumpy Road Ahead for U.S. Banks: Stay Away? - Industry Outlook

The solid support that cost containment efforts are lending to U.S. banks are being marred by lack of top-line growth and the ever-increasing need to spend more on cyber security and alternative business opportunities.

A dearth of overall loan growth and consequent pressure on net interest margin remains prominent with the persistent low interest rate environment, liquidity coverage rule (LCR) requirements and intense competition.

In an earlier piece (

), we provided the favorable arguments for investing in the U.S. banks space. But we would like to argue the opposite case in this piece to help you make the right call.

Low rates are forcing banks to cut interest expenses and ease underwriting standards. This is, in turn, increasing the chance of higher credit costs. Further, shifting assets to longer maturities -- the only course to strengthen net interest margin -- doesn't look appropriate now, as the expected increase in interest rates by mid 2015 could backfire.

On the other hand, the persistent low-interest-rate environment is having a mixed impact on banks. While it reduced their borrowing costs, limitation to charge high interest on loans hurt 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.

Banks' efforts to strengthen top line by focusing more on non-interest income have not been working effectively. 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 and still shaky economic recovery.

Further, increasing propensity to invest in alternative revenue sources on the back of an improved employment scenario may result in higher non-interest income. But grabbing good opportunities will require higher overhead.

Moreover, lingering legal and restructuring costs could strain the key strategy to stay afloat through cost containment.

Better-than-expected earnings have been the key driver of bank performance in the last few quarters, but primarily conservative estimates led to the surprises. Also, the ways banks are generating earnings seem a stopgap. Measures like forceful cost reduction and lowering provision may not last long as earnings drivers.

Continued narrowing of the gap between loss provisions and charge-offs will not allow banks to support the bottom line by lowering provision. Also, competing with other industry participants to grab new business opportunities would require significant spending.

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.

While the financials of banks have no doubt improved over the last few years, there is still a number of reasons to worry about the industry's performance going forward. So it would be a prudent decision to get rid of or stay away from some bank stocks that depict weak fundamentals and carry an unfavorable Zacks Rank.

Specific banks that we don't like with a Zacks Rank #5 (Strong Sell) are Independent Bank Group, Inc. (

), Union Bankshares Corp. (

) and Central Pacific Financial Corp. (

). We also don't recommend a few Zacks Rank #4 (Sell) banks including First Citizens Banc Corp. (

), Independent Bank Corp. (

), Hudson Valley Holding Corp. (

), OFG Bancorp (

) and Hilltop Holdings Inc. (

).

Check out our latest

here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy.

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