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In order to plan the path to future growth, banks all over the world are seeking new strategies to lessen the regulatory burden. Almost every bank has its focus on capital efficiency. And most of the foreign banks are adopting reconstruction-by-asset-sale strategies to strengthen their capital ratios.

Self-protective efforts are significantly helping these banks to stay afloat, though at the cost of moderating top and bottom-line growth. Moreover, the industry remains thwarted by non-stop challenges that are keeping its performance muted.

The latest deterrents, nagging macroeconomic issues -- the European sovereign debt crisis in particular -- and regulatory pressures, are continuously taking a toll on the financials of many banks, resulting in the sector’s underperformance.

As growth remains the primary focus of central banks, interest rates are not expected to increase at least in the next couple of years as inflation is not a major concern for most of the countries other than a few emerging economies. Thus, banks operating in a low interest rate environment will not be able boost revenue through interest income. On the other hand, non-interest revenue sources will be limited by regulatory restrictions.

Banks in emerging economies will, however, not face significant challenges related to interest income due to a not-too-low interest rate environment. Anti-inflationary measures of the central banks of these economies are expected to keep interest rates high. However, non-interest revenue challenges will persist.

Complying with stringent regulation is not a major concern for most of the banks, but it would be difficult to optimize business investments in the way banks run their businesses. So banks will need to reassess and restructure their operating models to be successful, which will take considerable time.

The Recent Past and Near Future

Despite a number of high-profile scandals, many of the world’s largest banks were able to gain investors’ confidence in 2012 as reflected by their share price performance. Many foreign banks, including giants like UBS AG
(UBS), Barclays PLC
(BCS) and HSBC Holdings plc
(HBC), ended the year with substantially higher share prices compared to the beginning of the year. Also, the MSCI World Bank Index increased more than 20% in 2012.

However, with respect to the financial health, less resilience was seen during the year than was anticipated. Growing challenges related to funding, still-high costs despite belt-tightening through layoffs and limited access to revenue sources kept bottom-line growth under pressure.

The upcoming quarters don’t look any better, with several negatives hampering the sector like asset-quality troubles, high borrowing costs, steeper expenses and weak loan demand. But thanks to worldwide regulatory reform, the sector has at least entered a transformation phase with the restructuring efforts in place. Needless to mention, an essence of growth has yet to be felt.

On the Fundamental Side

Looking at the fundamentals, a rising risk-aversion tendency has still kept client activity slowed, resulting in weak trading volumes and subdued credit demand. Also, learning from past experience, banks are now more cautious about lending money.

Consequently, lower business activities and anticipated subdued profitability are making foreign banks less appealing to investors. Valuation multiples of these banks will continue to reflect the fundamental challenges at least through the first half of 2013.

The growth potential of some non-U.S. banks could be restrained by higher reserve requirements and outsized losses related to capital markets. But strict lending limits as part of the regulatory overhaul as well as greater transparency in regulations could strengthen the fundamentals of many sector participants. Eventually, these are expected to create a less risky lane for the overall industry.

As inter-country investment walls have fallen, some large non-U.S. banks are freely expanding beyond their domestic boundaries through mergers and acquisitions to utilize regional regulatory benefits. On the other hand, regulatory pressure to focus more on the home market is forcing some global banking giants to sell overseas assets. Accordingly, banks are trying hard to restructure their operating models and address funding needs.

While the sector saw a moderate recovery in 2010, the performance in 2011 was among the poorest in its history. Then in 2012, the industry came across a number of new difficulties. But a risk-averse approach helped it perform better than 2011.

Primary Headwinds

The primary headwind for global banks is regulatory pressure, which ensued from taxpayers' money and government intervention that banks have relied on in order to remain in business. Regulatory reform is a key issue for banks over the last few years. The impact of regulations has yet to be fully felt with many rules still impending.

Moreover, government efforts to alleviate industry concerns have significantly raised political debates over time. Politics will continue to influence lending decisions as long as banks remain financially dependent on governments. 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 need for bailouts is still felt acutely by the European banks.

Adding to the concern is the tendency of regulators worldwide to agree on common minimum standards to prevent the recurrence of a global financial crisis and restore public confidence. The introduction of Basel III standards is a case in point.

With these regulatory measures, the individual capital structure of banks will remain under constant pressure. Also, the efforts to develop new business models will become much more expensive and difficult. However, 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 and provide a new set of opportunities.

Valuations Look Attractive

Balance sheet repair and credit environment recovery will make the valuations of some non-U.S. banks attractive going forward. 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 a good time for long-term investors to consider foreign bank stocks, as the valuations at present look comparatively cheaper.

Investors with short-term targets, however, should be watchful while choosing foreign bank stocks at this point as near-term fundamentals do not look promising. Asset quality lacks the potential to a 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 and a low interest rate environment in most of the countries.

If any improvement occurs in the near-to-mid term, it will vary from country to country, depending on industry circumstances.

Ratings Concerns

Rating downgrades remained a major threat for major global banks in 2012. Lingering macroeconomic issues and sovereign crises across Europe dampened the credit profile of many banks to a notable extent. This prompted the rating agencies to take negative rating actions on these banks during the year.

In July 2012, Moody's Investors Service, the rating arm of Moody's Corp.
(MCO), downgraded credit ratings of 15 systematically important banks in the U.S., U.K. and Europe. The downgrade was based on the agency’s concern related to these banks’ significant exposure to the volatility and expected losses from capital market activities.

In October 2012, Standard and Poor’s (S&P) downgraded three French banks due to rock-bottom French consumer confidence.

However, Moody's, in its global banking outlook for 2013, stated that the ratings of global banks are expected to be relatively stable. The rating agency will keep an eye on excessive risk-taking by banks to offset the negative effects of low interest rates, elevated sovereign risk for the European banks and impacts of regulatory reforms.

Eurozone Woes

European banks are expected to underperform in the upcoming quarters due to increasing capital pressure emanating from the ongoing debt crisis in the region.

Though the funding situation in Europe has improved to some extent backed by huge aids from the European Central Bank, there remain deep concerns related to the banks’ ability to meet capital requirements.

Italy and Spain showed signs of improvement with support from the government and European Central Bank, but conditions in Greece remain uncertain due to issues related to additional bailout funds.

European policymakers have taken a number of important steps including the purchase of government bonds by European Central Bank. These actions have helped the European markets to stabilize to some extent. However, the policymakers need to take additional steps to alleviate investor panic and restore confidence. Otherwise, the risk of a credit crunch will deepen further.

Overall, the European Union is trying hard to restore investor confidence as well as fundamentally reshape the continent’s banking system. The issue, however, remains far from being addressed.

Emerging Markets

Coming to the banks in emerging economies, the asset quality trouble is obvious. However, these are not plagued by other serious 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.

We believe that banks in emerging economies –– Chile, Brazil and India –– look more attractive, akin to certain regional banks in the U.S., Australia and Canada that have capital strength, good funding and growth potential.

Conclusion

Overall, a key determinant for a 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 performances.

Also, only cost reduction by job cuts and asset sales is no longer considered enough. Instead, the aim should be to enhance operational efficiency through fundamental changes in business models. The capital goal of global banks should be more than just complying with regulatory requirements. Banks need to reshape their operating models to convert regulatory mandates to opportunities.

On the other hand, the primary attention of policymakers should be on determining the span of fiscal stimulus, ensuring that it remains till a clear sign of transition from recovery to growth is visible.

OPPORTUNITIES

Among the non-U.S. banks, we recommend Banco Bilbao Vizcaya Argentaria S.A.
(BBVA), BBVA Banco Franc
(BFR), Bank of Communications Co. Ltd.
(BCMXY), China Merchants Bank Co. Ltd.
(CIHKY) and Shinhan Financial Group Company Ltd
(SHG) that have a Zacks Rank #1 (Strong Buy).

We also like banks with a Zacks Rank #2 (Buy) including Bank of Montreal
(BMO), Credit Suisse Group
(CS), ICICI Bank Ltd.
(IBN), KB Financial Group Inc.
(KB) and UBS AG
(UBS).

WEAKNESSES

We would suggest avoiding European banks at this point, including banks in Great Britain and Ireland. The weaker banks are those that have participated in government recapitalization programs and are yet to repay. In return of government capital and asset quality protection, these banks are facing regulatory intervention, like enforcing limits on dividend payouts and board member nominations.

Currently, the only bank we dislike with a Zacks Rank #5 (Strong Sell) is Erste Group Bank AG
(EBKDY).

We also dislike some stocks in the non-U.S. bank universe with the Zacks Rank #4 (Sell), namely Banco Santander, S.A.
(SAN), Barclays PLC
(BCS), Canadian Imperial Bank of Commerce
(CM), CorpBanca
(BCA), HDFC Bank Ltd.
(HDB) and Mitsubishi UFJ Financial Group Inc.
(MTU).