TCBK TriCo Bancshares

What’s in Store for U.S. Banks in 2013?

U.S. banks look ready for 2013 with uninterrupted expense control, sound balance sheets, an uptick in mortgage activity and lesser credit loss provisions. Moreover, a favorable equity and asset market backdrop, progressive housing sector and an accommodative monetary policy are expected to make the road to growth smoother.

Yet, a favor from top-line growth still remains uncertain due to expected sluggishness in loan growth, pressure on net interest margin from the sustained low rate environment and less flexible business model owing to stringent risk-weighted capital requirements (Basel III standard).

U.S. banks are actively responding to legal and regulatory pressures, indicating competence to encounter impending challenges. But the potency of the sector is not expected to return to its pre-recession peak anytime soon. Economic intricacies, both domestic and overseas, may even result in some more disappointments in the upcoming quarters.

Overall, structural changes in the sector will continue to impair business expansion and investor confidence. Several dampening factors – asset-quality troubles, mortgage liabilities and tighter regulations – will decide the fate of the U.S. banks in the year ahead. But entering the new capital regime will ensure long-term stability and security for the industry.

Clear Signs of Improvement

Progress seen in the first three quarters of this year gives a clear growth indication. Besides contraction in provisions for credit losses and cost containment, marked recovery in the bond and equity markets and consequent revenue growth helped most of the banks report higher-than-expected earnings. Expanding consumer credit and overall improvement in lending activity made it easy for banks to show continued improvement.

The third quarter in particular showed exceptional top-line growth. Revenue growth was the best since 2009 buoyed by solid growth in mortgage revenue. Most importantly, for the first time in almost three years, banks did not have to majorly depend on accounting tricks for increasing earnings, thanks to strong top-line growth.

Federal Deposit Insurance Corporation (FDIC)-insured commercial banks and savings institutions reported third-quarter earnings of $37.6 billion, outpacing year-ago earnings of $35.2 billion by nearly 6.6%. This marked the 13th straight quarter of year-over-year earnings increase.

More than half (57.5%) of all institutions witnessed year-over-year improvements in net income during the quarter primarily on improved top lines and reduced loan loss provisions. Major banks earned nearly 82.0% of the  total third-quarter profit. These include mammoth players like JPMorgan Chase & Co. (JPM) and Wells Fargo & Company (WFC), which commands a significant portion of the U.S. banking market.

The Zacks Consensus Estimate for JPMorgan is earnings of $1.22 per share for fourth quarter and $5.01 for full year 2012. Wells Fargo is expected to earn 89 cents per share in the fourth quarter and $3.35 in the full year. For 2013, earnings of JPMorgan and Wells Fargo are expected to increase 5.8% and 7.9% to $5.30 and $3.61 per share, respectively, indicating significant improvement in the key banking sector in 2013.

Fewer Bank Failures and Problem Institutions

During the third quarter, only 12 FDIC-insured banks failed -- the least in a quarter since fourth quarter 2008. As of December 14, 2012, the tally of failed banks came in at 51 compared with 90 in the year-ago period.

Moreover, as of September 30, 2012, the number of FDIC’s "problem institutions” declined from 732 to 694, which is the lowest since third quarter 2009.

Achieving Profitability Won't Be Easy

We don’t expect reduction in provisions for credit losses to significantly help earnings growth in the upcoming quarters as the difference between loss provisions and charge-offs is gradually decreasing.

Banks will definitely try to look at other areas -- interest income, non-interest income and operating costs -- to maintain earnings growth, but there will be limited opportunity given the expected weakness in lending activity due to regulatory restrictions, sluggish economic recovery and the so-called fiscal cliff.

Efforts to cut interest expenses and take additional risks to improve net interest margins could be marred by a flattening yield curve. Further, shifting assets to longer maturities for net interest margin strength could backfire once interest rates start rising.

Conversely, increasing revenues through non-interest sources – prepaid cards, new fees, higher minimum balance requirement on deposit accounts and encouraging credit cards – could be hampered by regulatory actions, economic volatility and soaring overhead. So, non-interest income can only marginally contribute to total revenue.

Eventually, banks will have to resort to cost containment through job cuts and reduced size of operations to stay afloat. So, any cost-cutting measure will act as a defense. The last four years saw about half a million banking layoffs, and the story continues.   

What QE3 and “Fiscal Cliff” Mean for Banks?

While the quantitative easing or QE3 effort of the central bank is expected to stimulate loan demand, wholesale recovery in lending activity is unlikely with memories of recession and job loss keeping customers away. But, QE3 will definitely help banks with respect to generating loans to some extent.

Then again, if the U.S. steps off the fiscal cliff, which enforces tax hikes and spending cuts, interest rates will remain low and net interest margin will fail to improve. Also, likely changes in the capital gains tax due to fiscal cliff will sidetrack many businesses from loans.

Balance Sheet Recovery to Take Time

Steady deposit growth from lack of low-risk investment opportunities post financial turmoil is quite possible, but high charge-offs and delinquency rates plus weak demand could keep loan growth under pressure next year.

Banks are trying to address asset-quality troubles by divesting nonperforming assets, but we don’t expect balance sheets strength to return anytime soon.

Basel III: A Major Concern

The implementation of Basel III requirements from 2013 will boost minimum capital standards. But adjusting liquidity management processes will cause a short-term negative impact on the financials of U.S. banks.

This will ultimately make credit costlier and reduce employment. But a greater capital cushion will help larger banks withstand internal and external shocks over the long run.

Macro Backdrop Still Uncertain?

Though improved economic data such as higher consumer spending and gross domestic product (GDP), improving housing market and declining unemployment rate point towards optimism, a paltry interest-rate environment is disturbing. Also, uncertainty over fiscal cliff could keep economic growth tardy.

The European debt crisis will exacerbate the situation. Though the U.S. commercial banks appear to have significant direct and indirect exposure to Europe, potential costs are expected to be manageable. But if the crisis deepens, worldwide capital markets will face a big blow, and the U.S. will not be left unscathed.

OPPORTUNITIES

Though the improving performance of banks seems already priced in and there remains substantial concerns, the sector’s performance in the upcoming quarters should not disappoint investors.

Specific banks that we like with a Zacks #1 Rank (short-term Strong Buy rating) include ViewPoint Financial Group (VPFG), BofI Holding (BOFI), Preferred Bank (PFBC), TriCo Bancshares (TCBK), Cardinal Financial Corp. (CFNL), M&T Bank Corporation (MTB), Macatawa Bank Corp. (MCBC) and Tompkins Financial Corporation (TMP).  

Stocks in the U.S. banking universe with a Zacks #2 Rank (short-term Buy rating) currently include BOK Financial Corporation (BOKF), Texas Capital BancShares (TCBI), Central Pacific Financial (CPF), Fidelity Southern Corporation (LION), BankUnited, Inc. (BKU), First Business Financial Services (FBIZ) and Washington Trust Bancorp (WASH).  

WEAKNESSES

The profitability metrics (like returns on equity and return on assets) are expected to be under pressure. Further, difficulty in liquidity management due to regulatory restrictions will restrict top-line growth.  

There are currently four stocks with a Zacks #5 Rank (short-term Strong Sell rating). These are Bank of Marin Bancorp (BMRC), CVB Financial Corp. (CVBF), Porter Bancorp Inc. (PBIB), State Bank Financial Corporation (STBZ) and Park National Corp. (PRK).
 
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