Non-U.S. Banks Stock Update - July 2011

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Backed by worldwide regulatory reform, the global banking industry is currently going through a transformation phase. Though the growth potential of some non-U.S. banks could be subdued due to higher reserve requirements, increased property taxes and strict lending limits as part of the regulatory overhaul, greater transparency in regulation could strengthen the fundamentals of many banks. Moreover, it is expected to create a less risky lane for the overall industry.

Since 2010, the banking sector has been recovering at a moderate pace from the latest financial crisis that started as a credit issue in the subprime enclave of the U.S. mortgage market in mid-2007 and spilled all over the globe.

Though the malice spread by the financial crisis is behind us, banks are now dealing with regulatory pressure as they had to take resort to taxpayers' money and government intervention to remain afloat. Moreover, government efforts to alleviate industry concerns have significantly raised political hurdles in the sector over time.

Politics will continue to influence lending decisions of banks until they repay the government money in full. According to banking regulators, if governments withdraw their support from banks before giving them sufficient time to restore their financial strength, the sector could collapse again.

The industry has been adopting tougher regulatory measures to prevent the recurrence of a global financial crisis and restore public confidence. In June, the oversight body of the Basel Committee on Banking Supervision proposed new rules that would force the world's biggest banks to hold extra capital on their balance sheets as protection and prevention against any financial catastrophe. The targeted banks are those that could threaten global economy if they collapse.

This extra capital requirement is an addition to the set of minimum capital standards, known as Basel III, proposed by regulatory officials of more than two dozen countries in 2010.

Under the proposed rule, mega banks worldwide would have to maintain an extra 1% to 2.5% of capital on their balance sheets in addition to the Basel III mandate of 7%. The percentage will vary, depending on the size of their balance sheets. The Basel Committee will allow the target banks three years –– 2016 to 2018 –– to meet the new capital requirements.

The Swiss government was an early bird, proposing to increase the minimum common equity requirement to 10% for UBS AG (NYSE:UBS - News) and Credit Suisse Group (NYSE:CS - News).

With these regulatory measures, the individual capital structures of banks will remain under constant pressure. The resulting slowdown at some big banks could be seen as a blessing in disguise as it would eventually make their balance sheets more recession-proof.

Balance sheet repair and credit environment recovery will make the valuations of some non-U.S. banks attractive. Particularly, valuations of the mega banks, which could comfortably maintain the minimum capital norms mandated by the Basel Committee, will experience the fastest valuation upside. Consequently, we believe this would be the perfect time for mid- to long-term investors to consider non-U.S. bank stocks, as their valuations are now comparatively cheap.

Investors with short-term targets, however, should be very careful while choosing non-U.S. stocks at this point as near-term fundamentals remain weak; asset quality lacks potentiality to rebound anytime soon as default rates for individuals and companies are not expected to materially subside; and revenue growth might remain weak with faltering loan growth.

The sector anticipates an upturn in the second half of 2011. But this will vary from country to country, depending on industry circumstances. We believe that banks in emerging economies –– Chile, Brazil or India –– might make more attractive investments, akin to our expectations from certain regional banks in the U.S.

The same, however, cannot be said of European institutions. In early 2010, the debt crisis originating in the Greek economy shook the stability of the European Union's (NYSEArca:EU - News) monetary policies. Starting as a solvency crisis in a single country, the turmoil threatened the entire Euro-zone.

Greece adopted measures to minimize government spending and stress test results were largely reassuring, but there is no guarantee that the country is out of the woods as affluent domestic and foreign investors will not stop withdrawing their money from Greek banks anytime soon. Also, rising inflation will force regulators to tighten their policies in the Euro-zone, making banks less flexible.

In May 2011, related to the refinancing of public debts, the crisis in Greece re-emerged. Political instability further compounded the problem. However, the situation is now under control with the intervention of the Greek government and financial assurance from European Union leaders.

Overall, the European Union is making progress in restoring faith and confidence of investors as well as the health of the continent’s banking system, but the issue is far from fully addressed.

Coming to banks in emerging economies, they will obviously face asset quality issues. However, they are not plagued by other significant problems that many of the larger banks face in continental Europe and the United Kingdom, such as toxic securities and dilution from capital raising. Moreover, these emerging-market banks generally tend to be well capitalized, aren't as heavily exposed to property markets, and have significant and growing sources of non-interest income.

Banks are finally learning from the crisis they created. In 2010, banks in emerging economies performed remarkably well in serving as a stabilizing force in global economic recovery.

Overall, a key determinant for quick recovery will be the quality of risk analysis and risk-awareness in decision-making and incentive policies. So, we believe that accumulating larger capital buffers over the cycle and reducing pointless complexity in business will be crucial to banking performance.

Also, the primary attention of policymakers should be on determining how much longer the fiscal stimulus should continue, ensuring that it is not withdrawn before a clearer sign of economic recovery is visible.

OPPORTUNITIES

Currently, financial institutions in the Zacks covered non-U.S. bank universe with a Zacks #1 Rank (Strong Buy) are Banco Bilbao Vizcaya Argentaria, S.A. (NYSE:BBVA - News) and Grupo Financiero Galicia S.A. (NasdaqCM:GGAL - News). Banks that we like with a Zacks #2 Rank (Buy) include Banco Bradesco S.A. (NYSE:BBD - News), Itau Unibanco Banco Holding S.A. (NYSE:ITUB - News), Deutsche Bank AG (NYSE:DB - News), National Australia Bank Limited (:NAZBY), Shinhan Financial Group Co. Ltd. (NYSE:SHG - News) and Westpac Banking Corporation (NYSE:WBK - News).

We also like HDFC Bank Limited (NYSE:HDB - News) and ICICI Bank Limited (NYSE:IBN - News) in India with a Zacks #3 Rank (Hold). Both of these banks have recently been emphasizing strong cost controls and improved operating efficiency, rather than growth, as key strategies. As a result, these banks have been able to offset some of the earnings pressure from higher loss provisions due to weakening asset quality. We anticipate continued synergies from these banks’ cost-containment measures and operating efficiency.

Other Zacks #3 Rank stocks in the non-U.S. bank universe include Banco Santander-Chile (NYSE:SAN - News), Banco de Chile (NYSE:BCH - News), Banco Santander, S.A. (NYSE:STD - News), Bank of Montreal (NYSE:BMO - News), The Bank Of Nova Scotia (NYSE:BNS - News), Canadian Imperial Bank of Commerce (NYSE:CM - News), Credit Suisse Group, UBS AG, KB Financial Group, Inc. (NYSE:KB - News) and Royal Bank of Canada (NYSE:RY - News).

WEAKNESSES

We would suggest avoiding banks in Greece at this point. Also, it is better to steer clear of banks in Great Britain and Ireland, particularly those that have participated in government recapitalization programs and have yet to reimburse the money. In return for government capital and asset quality protection, these banks are facing regulatory intervention, like enforcing limits on dividend payouts and board member nominations.

Currently, there are three stocks in the Zacks covered non-U.S. bank universe with a Zacks #4 Rank (Sell), namely Lloyds Banking Group plc (NYSE:LYG - News), National Bank of Greece SA (NYSE:NBG - News) and The Toronto-Dominion Bank (NYSE:TD - News).

Specific banks that we dislike with a Zacks #5 Rank (Strong Sell) are Barclays plc (NYSE:BCS - News) and HSBC Holdings plc (NYSE:HBC - News).

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