U.S. Markets closed

Downside Risks in Banks Could Shift Investors' Focus

Kalyan Nandy
Downside Risks in Banks Could Shift Investors' Focus

The benefits of a rising rate environment, tax overhaul and an expected ease in regulation have helped U.S. banks gain significantly over the past six months, but there are some downside risks that could shift investors’ focus from the industry.

Primarily, the muted earnings growth that the industry has been witnessing for the last few quarters could raise investors’ concerns and tarnish the optimism over the benefits from policy changes and reforms.

Also, investors’ enthusiasm may wane if the actual benefits don’t meet investors’ expectations or take too long to come.

While there is no indication of disruption in the interest rates moving higher, the yield curve is yet to reach a state where a continued steepening can be predicted. In fact, many forecasters expect the term spread — the difference between long-term and short-term interest rates —to shrink. This could spell trouble for banks.

While rolling back tough post-financial-crisis banking regulations is expected to benefit small and mid-size lenders, the benefits may fail to meet investors’ expectations.

Moreover, softer regulations might benefit banks’ earning mostly from domestic operations. However, larger banks with significant international exposure might lose out on competitiveness due to ever-increasing international regulatory standards. Further, meeting international standards will restrict them from generating domestic revenues.

Though it is too early to make any negative assessment of the likely regulatory overhaul, easier lending standards and lesser regulatory restrictions could increase credit costs for banks, similar to what the industry witnessed just before the recession.

Moreover, there are a number of fundamental challenges that might hold banks back from growing steadily.

Expense reduction was the key measure that helped banks stay afloat for long. But it may not be a major support going forward, as banks have already cut the majority of unnecessary expenses.

Banks’ proactive actions to move beyond defensive steps like cost containment were also effective in supporting their bottom line over the last few quarters. However, these are not enough to make the growth path steady, as emerging issues like cybercrime and unconventional competition (from fintech and other technology firms) are piling up. For example, if big companies like Amazon (AMZN) and Alphabet (GOOGL) enter the banking space, existing banks could lose significant market share.

While results for the last few quarters show respite from high legal costs, higher spending on cyber security, technology, analytics and alternative business opportunities will keep costing a pretty penny.

In an earlier piece (Are U.S. Banks on the Verge of a New Golden Era?), we provided arguments in favor of investing in the U.S. banking space. But here we would like to discuss some points that subshttps://www.zacks.com/commentary/153649/us-banks-stock-outlook---march-2018tantiate the opposite case.

Quality of Earnings Has Weakened

Banks have been delivering better-than-expected earnings for quite some time now, but the positive surprises have mostly been backed by conservative estimates. Promising low and then impressing the market with an earnings beat has been the tactic.

While year-over-year comparisons remained positive over the last several quarters, the industry witnessed decelerating earnings growth rates.

Strengthening Non-Interest Revenues Requires Higher Overhead

Banks’ strategies to generate more revenues from non-interest sources are working well, but the sources are not yet dependable.

On the other hand, grabbing any opportunity to generate higher non-interest revenues amid improving employment and wage scenario requires higher overhead.

Banks Will Be Better Off With Higher Rates, But It's Not All Good

In order to survive in the prolonged low interest rate environment, banks reduced their dependence on rate-sensitive revenues and focused more on alternative revenue sources. So, rising rates may not immediately benefit banks as much as they did in the pre-crisis period.

Banks will not have to compete for deposits and pay higher rates for some time, as the lack of low-risk investment opportunities in a low-rate environment helped them attract huge deposits. However, the excess deposits will dry up after some time and competition for deposits will intensify as a consequence of the Fed’s balance sheet unwinding. If this happens, the current practice of capping the cost of funding by keeping the rates on deposits almost unchanged won’t help margin expansion.

Further, credit quality, an important performance indicator for banks, may not improve with rising interest rates if there is lesser regulatory supervision. The prolonged low interest rate environment has already forced banks to ease underwriting standards, which, in turn, has increased the odds of higher credit costs.

Absorbing Future Losses Could Be Difficult

In the United States, accounting rules allow banks to record a small part of their derivatives and not show most mortgage-linked bonds. So there might be risky assets off their books. As a result, capital buffers that U.S. banks have been forced to maintain so far might not be enough to fight risks of a default. Likely lesser restriction on capital in the future would make dealing with a default even more difficult.

Stocks to Stay Away from

Despite the expected benefits from the reforms and rising interest rates, there are a number of reasons to worry about the industry’s performance in the near to medium term. So it would be prudent to get rid of or stay away from some weak bank stocks for now. Stocks carrying a Zacks Rank #5 (Strong Sell) or #4 (Sell) are particularly expected to underperform.

Here are a few stocks that you should stay away from:

County Bancorp, Inc. (ICBK): This Zacks Rank #5 stock has gained just 1.5% over the past six months versus the S&P 500’s gain of 10.8%. The stock’s earnings estimates for the current year have been revised 4.9% downward over the last 60 days.

Howard Bancorp, Inc. (HBMD): A 6.7% downward revision in earnings estimates for the current year over the last 60 days precipitated a Zacks Rank #5 for this stock. The stock has lost nearly 5% in the past six months.

Franklin Financial Network, Inc. (FSB): This Zacks Rank #5 stock has lost 0.4% over the past six months. The stock’s earnings estimates for the current year have been revised nearly 3% downward over the last 60 days.

Fidelity Southern Corporation (LION): More than 12% downward revision in earnings estimates for the current year over the last 60 days precipitated a Zacks Rank #5 for this stock. The stock has gained 8.3% in the past six months.

(Check out our latest U.S. Banks Stock Outlook for a more detailed discussion on the fundamental trends.)

Can Hackers Put Money INTO Your Portfolio?

Earlier this month, credit bureau Equifax announced a massive data breach affecting 2 out of every 3 Americans. The cybersecurity industry is expanding quickly in response to this and similar events. But some stocks are better investments than others.

Zacks has just released Cybersecurity! An Investor’s Guide to help Zacks.com readers make the most of the $170 billion per year investment opportunity created by hackers and other threats. It reveals 4 stocks worth looking into right away.

Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report
Fidelity Southern Corporation (LION) : Free Stock Analysis Report
County Bancorp, Inc. (ICBK) : Free Stock Analysis Report
Howard Bancorp, Inc. (HBMD) : Free Stock Analysis Report
Alphabet Inc. (GOOGL) : Free Stock Analysis Report
Franklin Financial Network, Inc. (FSB) : Free Stock Analysis Report
To read this article on Zacks.com click here.
Zacks Investment Research