Zacks Industry Outlook Highlights: Wells Fargo, Citigroup, Commerce West Bank, N.A., OFG Bancorp and Franklin Financial Network
Zacks Equity Research
Updated
For Immediate Release
Chicago, IL – April 07, 2016 – Today, Zacks Equity Research discusses the U.S. Banks, (Part 3), including Wells Fargo (WFC), Citigroup (C), Commerce West Bank, N.A. (CWBK), OFG Bancorp (OFG) and Franklin Financial Network, Inc. (FSB).
Lackluster performance by U.S. bank stocks even as the economy entered a rising rate cycle indicates concerns over the industry’s ability to endure the slump in crude oil prices, collapse of commodity prices and global economic threats. Uncertainty over the Fed’s rate hike schedule has also made investors pessimistic about quick benefits that banks could have reaped from improved net interest margins – the difference between deposit rates and lending rates.
Banks’ exposure to the distressed energy sector has added to the gloom. Concerns that the crude carnage might affect the outstanding energy debt may have forced banks to set aside money to cover the loss. And this could curb their earnings.
While it might not be too big a constraint for the major U.S. lenders like Wells Fargo (WFC) and Citigroup (C) as energy represents a small portion of their loan portfolio, small banks with significant energy exposure could be hit hard. Overall, the likely default of the energy companies can end up hurting the earnings of a number of banks.
Further, though the earnings performance by U.S. banks was not discouraging in the past few quarters, it was mainly attributable to the temporary defensive measures that they adopted to tide over the legacy as well as new challenges. While banks are working out ways to reduce their dependence on defensive measures through aggressive strategies, burning issues like cybercrime, regulatory compliance and unconventional competition will keep their financials strained.
Banks are trying every means to contain costs, either by closing lackluster operations or by laying off personnel. Yet nonstop legal expenses plus higher spending on cyber security, analytics and alternative business opportunities are costing a pretty penny.
Added to these is the inconsistent performance by the key business segments and dull top-line growth.
The dearth of overall loan growth and the consequent pressure on net interest margin remains prominent. Though recovering economic conditions and easier lending standards should beef up the loan volume and the likely hike in rates should ease some pressure on net interest margin, the benefit may not be realized any time soon given the Fed’s plan to raise rates at a slower pace.
In an earlier piece (What Keeps the Prospects Alive for U.S. Banks), we provided arguments in favor of investing in the U.S. banks’ space. But here we would like to argue the opposite case.
Rate Hike Might Not Turn Positive as Expected
Banks will benefit from rising interest rates only if the increase in long-term rates is higher than the short-term ones. This is because banks will have to pay less for deposits (typically tied to short-term rates) than what they charge for loans (typically tied to long-term rates). This opposite case will actually hurt net interest margin.
Banks will not have to compete for deposits and pay higher rates for some time, as they already have excess deposits that they gathered by capitalizing on the lack of low-risk investment opportunities in a low-rate environment. However, the excess deposits will dry up after some time. And if short-term rates are higher than the long-term ones, the interest outflow for maintaining the required deposits will be higher than the inflow of the same from loans.
On the other hand, credit quality -- an important performance indicator for banks -- should improve with the interest rate hike. But the prolonged low interest rate environment has forced banks to ease underwriting standards for long. This, in turn, has increased the chance of higher credit costs for quite some time.
Absorbing Future Losses Won’t Be Easy
U.S. 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, the capital buffers that U.S. banks are forced to maintain might not be enough to fight the risks of a default.
Also, if the energy sector witnesses any further collapse, banks will have to build up more cash reserves to cover their losses from energy loans. This will have a significant impact on their earnings. On the other hand, prohibiting drillers from their loan portfolio could end up doing more damage, as it will reduce the chance of repayment of the money that they have already lent.
Alternative Revenues Yet to Be Steady
Banks’ strategies to focus more on non-interest revenue sources for strengthening their top line have not been smooth sailing. Opportunities for generating non-interest revenues -- from sources like charges on deposits, prepaid cards, new fees and higher minimum balance requirement on deposit accounts -- will continue to be curbed by regulatory restrictions.
While the greater propensity to invest in alternative revenue sources on the back of an improved employment scenario might result in higher non-interest revenues, grabbing good opportunities will require a higher overhead.
Quality of Earnings Could Drag
Better-than-expected earnings have been the key drivers of banks’ performance in the last few quarters, but the surprises have mostly been helped by conservative estimates. Promising low and then impressing the market with an earnings beat is the trend.
Also, the way of generating earnings seems a stopgap. Measures like forceful cost reduction and lowering provision may not last long as earnings drivers. Further, continued narrowing of the gap between loss provisions and charge-offs will not allow banks to support the bottom line by lowering provision.
Unless the key business segments revitalize and generate revenues that could more than offset the usual growth in costs, bottom-line growth will not be consistent.
Stocks to Dump Now
There are a number of reasons to worry about the industry’s performance in the short to medium term. So it would be prudent to get rid of or stay away from some weak bank stocks for now. Stocks carrying an unfavorable Zacks Rank are particularly expected to underperform.
We suggest dumping Commerce West Bank, N.A. (CWBK), OFG Bancorp (OFG) and Franklin Financial Network, Inc. (FSB), as they carry a Zacks Rank #5 (Strong Sell).
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