EBTX Encore Bancshares, Inc. (MM)

The U.S. banks appear well placed to perform relatively better through the remainder of 2012 on lesser pressure on trading income, uninterrupted expense control and a slowdown in the provision for credit losses. At least the progress seen in the first quarter gives this indication.

Though marked recovery of the bond and equity markets and consequent revenue growth pushed the first quarter results a bit higher than expected, core dynamics also showed strength.

Moreover, financial institutions are actively responding to every legal and regulatory pressure. This has positioned the banks well to encounter impending challenges.

However, the potency of the sector is not expected to return to its pre-recession peak anytime soon. The economic intricacies may even result in further disappointments in the upcoming quarters.

As the sector is undergoing a radical structural change, it will witness headwinds in the near to mid-term. But entering the new capital regime will ensure stability and security in the industry over the long term.   

Along with increasing earnings, a major recovery in the asset markets, improving balance sheets and declining credit costs promise growth for the U.S. banking sector, though at a slower-than-normal pace. The dampening factors -- such as issues related to the mortgage liabilities, asset-quality troubles, weak loan demand, and the impact of tighter regulations and policy changes -- are expected to remain tied to the fate of U.S. banks in the upcoming quarters.

Looking back, after enduring overwhelming recessionary shocks, the U.S. banking industry has gradually started recovering in the recent years. Actually, financial support from the U.S. government ultimately transformed into stability.

The government undertook several steps, including programs offering capital injections and debt guarantees, to stabilize the financial system. The banks are also working hard to address problem credit, primarily in residential and commercial real estate. Commercial real estate loan performance is expected to show strong improvement over the year.

Earnings Growth Hard to Come By

Though reduced loss provisioning has helped the industry witness strong earnings growth over the last couple of years, we don’t expect a significant pickup in upcoming earnings from provision reductions, as the difference between loss provisions and charge-offs is gradually reducing.

Banks will definitely try to look at other areas -- interest income, non-interest income and operating costs -- to keep the earnings growth intact, but we don’t see any significant opportunity with respect to the top line in the upcoming quarters.

Interest income will remain under pressure due to low interest rates and sluggish loan growth. Though banks will try to cut interest expenses and take additional risks to improve net interest margins, the flattening of the yield curve will mar these efforts.

Ultimately, banks will be forced to face lower margins. In fact, if the banks shift assets to longer maturities to keep net interest margin strong, this could backfire once interest rates start rising.

On the other hand, attempts to boost revenues through non-interest sources -- introducing new fees, increasing minimum balances requirement on deposit accounts and encouraging customers to use credit cards -- could be hampered by ongoing regulatory actions, a volatile global economy and soaring overhead. So, non-interest income will be able to marginally contribute to total revenue.

Lower industry revenue will finally force these banks to cut costs in order to stay afloat. As a result, banks will continue cutting jobs and reducing the size of operations by selling non-core assets. So, any cost-cutting measure will act as a defense.

Balance Sheet Recovery to Take Time

Since last year, banks have been trying to address asset-quality troubles through the disposition of nonperforming assets. Also, non-core asset shedding has become an industry trend, as banks have no other alternative but to keep capital ratios above regulatory requirements.

This non-core asset-selling, along with elevated charge-offs and weak demand, will likely keep loan growth under pressure in the near to mid-term. Moreover, heightened regulatory restrictions and soaring delinquency rates will act as headwinds. However, banks will experience steady deposit growth on the lack of low-risk investment opportunities due to the global economic turmoil and volatility in equity markets.

So we don’t expect a significant strength in balance sheets to return anytime soon.

Regulatory Threats to Growth

Following the latest recession, the regulatory environment has become tougher and costlier for the U.S. banks. In the last several quarters, banks had to face a number of regulatory requirements under several laws, including the Dodd-Frank legislation, the Durbin Amendment and the Volcker Rule.

Many other regulatory headwinds are expected to hinder growth in the upcoming quarters as regulators focus on global alignment. Though the aim is to meaningfully change the business models of banks to make them self-sufficient over the longer term, the cost of compliance will drag down profitability in the near to mid term.

While the implementation of the Basel III requirements will boost minimum capital standards, there will be a short-term negative impact on the financials of U.S. banks as they will have to adjust their liquidity management processes. But a greater capital cushion for the larger banks will add to their ability to withstand internal and external shocks in the long run. However, banks will get the time to strengthen their capital position as the Basel III requirements will be gradually introduced during the 2013 to 2019 period.

Macroeconomic Headwinds

There are several macroeconomic factors that may weigh on the profitability of the U.S. banks. The most crucial among these is the uncertain outlook for the U.S. economy.

Though improved economic data -- such as rising consumer spending and relatively lower unemployment -- point to optimism, the economy has been witnessing a lot less momentum in the first half of 2012 than was anticipated earlier. Concerns have crept up in the slothful stock market, exacerbated by ongoing concerns related to the European debt crisis.

Though the U.S. commercial banks appear to have significant direct and indirect exposure to Europe, the potential costs are expected to be manageable. However, if the crisis extends further, there will be significant impact on worldwide capital markets, and the U.S. will not be left unscathed. Consequently, U.S. banks would then face increased challenges.  

On the other hand, the extremely low interest-rate environment is another manifestation of this uncertain macro backdrop. Concerns about European finances and soft U.S. growth prospects have made treasury instruments the choice of safe asset class. As a result, yields on benchmark treasury bonds have hovered at low levels.

Bank Failures Continue

While the financials of a few large banks continue to stabilize on the back of the economic recovery, the industry is still on shaky ground. The sector presents a picture similar to that of 2011, with nagging issues like depressed home prices along with still-high loan defaults and unemployment levels troubling such institutions.

The lingering economic uncertainty and its effects also weigh on many banks. The need to absorb bad loans offered during the credit explosion has made these banks susceptible to severe problems.

Furthermore, government efforts have not succeeded in restoring lending activity at the banks. Lower lending will continue to hurt margins, though the low interest rate environment should be beneficial to banks with a liability-sensitive balance sheet.

Increasing loan losses on commercial real estate could trigger many more bank failures in the upcoming years. However, considering the moderate pace of bank failures, the 2012 number is not expected to exceed the 2011 tally. From 2011 through 2015, bank failures are estimated to cost The Federal Deposit Insurance Corporation (FDIC) about $19 billion.

Eventually, the strong banks will continue to take advantage of strategic opportunities, with the big fish eating the little ones.

Conclusion

Clearly, the banking system is still not out of the woods, as there are several nagging issues that need to be addressed by the government before shifting the strategy to growth.

However, before the banking sector regains investors’ confidence, it is likely to meet several disappointments on the way that would partially offset positive developments.

OPPORTUNITIES

The regulatory requirement of focusing on banking institutions toward higher-quality capital will help banks absorb big losses. Though this would somewhat limit the profitability of banks, a proper implementation would bring stability to the overall sector and hopefully keep bank failures in check.

Specific banks that we like with a Zacks #1 Rank (short-term Strong Buy rating) include U.S. Bancorp (USB), BancFirst Corporation (BANF), Encore Bancshares, Inc. (EBTX), Texas Capital BancShares Inc. (TCBI), Heartland Financial USA Inc. (HTLF), Lakeland Financial Corp. (LKFN), Macatawa Bank Corp. (MCBC), Central Pacific Financial Corp. (CPF), Heritage Commerce Corp. (HTBK), Access National Corp. (ANCX) and Center Bancorp Inc. (CNBC).  

There are currently a number of stocks in the U.S. banking universe with a Zacks #2 Rank (short-term Buy rating). These include BB&T Corporation (BBT), Comerica Incorporated (CMA), Fifth Third Bancorp (FITB), JPMorgan Chase & Co. (JPM), BOK Financial Corporation (BOKF), Cullen/Frost Bankers, Inc. (CFR), Metrocorp Bancshares Inc. (MCBI), Southwest Bancorp Inc. (OKSB), Associated Banc-Corp (ASBC), Commerce Bancshares, Inc. (CBSH), Huntington Bancshares Incorporated (HBAN), Western Alliance Bancorporation (WAL), BancorpSouth, Inc. (BXS), Regions Financial Corp. (RF), Hudson Valley Holding Corp. (HVB) and Webster Financial Corp. (WBS).       

WEAKNESSES

The financial system is going through massive deleveraging, and banks in particular have lowered leverage. The implication for banks is that profitability metrics (like returns on equity and return on assets) will be under pressure.

There are currently three stocks with a Zacks #5 Rank (short-term Strong Sell rating). These are State Bank Financial Corporation (STBZ), Orrstown Financial Services Inc. (ORRF) and Shore Bancshares, Inc. (SHBI).

 
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