Foreign Banks Stock Outlook: February 2014

As the Fed continues to scale back stimulus in the U.S., growth in the emerging economies lose steam because of liquidity reduction. But improvements in Europe and China have been able to offset the negativity, lending a positive sentiment to the worldwide economy. The non-U.S. banking space is fast catching up with this progress and has impressed with signs of improvement in recent quarters.

Of course, the improvement varies across locations depending on the ability to grab opportunities stemming from the wave of worldwide economic growth. But repositioning of business fundamentals to withstand any further crisis remains the trend.

Steady growth in non-U.S. banks is stemming from the proactive steps taken by the central banks of most developed and emerging economies. But the global financial system is yet to show tidiness to ensure a steady backdrop for banks.

Policy makers’ efforts to avoid another collapse have resulted in the flurry of banking regulations around the world. This is taking a toll on banks’ top and bottom lines, but the institutions are chalking out new strategies to counter regulatory burdens and plan future growth.

As capital efficiency is the key to survival, most foreign banks are adopting reconstruction-by-asset-sale strategies to strengthen capital ratios. While this will make their business safer, growth prospects don’t look impressive with thinning sources of income. Also, the sector must continue to fight macroeconomic challenges that limit growth opportunities.

Moreover, a prolonged low interest rate environment is not expected to reverse any time soon as central banks of most of the countries will continue to prioritize growth over inflation control. This strategy is sustainable as inflation is the concern of only 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 consumption-driven economies will not, however, face significant challenges related to interest income due to a not-too-low interest rate environment. Still-high inflation will continue to force the central banks of these economies to keep interest rates higher than the low-inflation economies. However, non-interest revenue challenges will persist for these banks as well.

Stringent regulation is a prolonged difficulty in optimization of business investments for non-U.S. banks. This leaves restructuring of operating models as the only growth driver. Most of the banks are resorting to the required measures, but a significant transformation will happen in its own time.

What to Expect Down the Road?

Funding insufficiency, not-so-effective cost control measures, and limited access to revenue sources will keep bottom-line improvement under pressure in the upcoming quarters.

Moreover, the impact of tighter regulations is yet to be fully felt with many rules still to be implemented across jurisdictions. Continued attempts by regulators worldwide to agree on strict capital standards and clip the risk-taking attitude of banks so as to prevent the recurrence of a global financial crisis will restrain the growth potential of some industry participants.

The full implementation of the Basel III standards – the risk-proof capital standard agreed upon by regulators across the world – is due in 2018. Though some non-U.S. banks have already started complying with the requirements, many are yet to make headway. To add to the difficulty, the latest changes indicate that banks need to hold more capital than what the Basel Committee mandated initially.

Nonetheless, strict lending limits 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.

Fed Rules: A New Concern

The Federal Reserve is set to implement stricter capital rules for foreign banks such as Deutsche Bank AG (DB) and Barclays plc (BCS) with sizeable operations in the U.S. According to the new rules, the U.S. operations of foreign banks need to hold as much capital as their U.S. peers.

This will force foreign banks to transfer their costly capital from their home country to the U.S. So their overall profitability could suffer as they need to spend more for the same business in the U.S.

Eurozone Sustains Recovery

The downside risk of the European economy appears much lesser than what it was a year ago. The economy showed continuous growth in the last three quarters following the end of an 18-month recession. It is believed that growth in the concluding quarter of 2013 was primarily driven by exports, but a sharp rise in consumer confidence, expansion of manufacturing output and faster-than-expected growth in private-sector business activities confirm the fundamental recovery of the economy.

The stain of Eurozone woes on global banks has faded without doubt. In fact, this has been translating into strength for some of the non-U.S. banking giants.

The steps taken by European policymakers have significantly helped in stabilizing the economy. Primarily, the European Central Bank’s (ECB) long-term refinancing operations have helped in injecting liquidity into the system. Further, the continent has been progressing well with respect to setting up a banking union, which will allow the ECB to intervene directly in banking operations within the continent.

The banking union will be authorized to supervise large banks in countries that use the euro. This should help banks to tidy up and ensure consumer protection in economically weaker countries like Spain, Italy and Portugal. This will in turn make the banking activities more transparent and support the continent’s economic recovery.

Behind Emerging Market Banks

Tapering of stimulus in the U.S. is taking the luster off banks in emerging markets. Actually, these markets have so long grown on the back of inflow of infused capital from the U.S. economy. Now, with liquidity levels drying up, the banking sector in these markets face the risk of a slowdown.

Moreover, the asset quality trouble is still obvious. But this is not as severe as the problems that many of the larger banks face in continental Europe and the United Kingdom – such as toxic securities and subdued capital raising.

Hopefully, less exposure to property markets and steady interest income from a not-too-low interest rate environment will help these banks offset the negatives to some extent.

Conclusion

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

Also, only cost reduction by job cuts and asset sales should no longer be considered enough. Instead, the aim should be to enhance operational efficiency through fundamental changes in business models. The capital goal of non-U.S. banks should be more than just obeying regulatory requirements.

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

OPPORTUNITIES

Shinhan Financial Group Company Limited (SHG) is the only bank carrying a Zacks Rank #1 (Strong Buy) in our non-U.S. bank universe. We also recommend banks with a Zacks Rank #2 (Buy) including HDFC Bank Ltd. (HDB), Lloyds Banking Group plc (LYG), The Royal Bank of Scotland Group plc  (RBS) and National Australia Bank Limited (NABZY).

WEAKNESSES

Currently, three banks we dislike with a Zacks Rank #5 (Strong Sell) are Australia & New Zealand Banking Group Limited (ANZBY), Grupo Financiero Santander Mexico, S.A.B. de C.V. (BSMX) and Westpac Banking Corporation (WBK).

We also dislike some stocks in the non-U.S. bank universe with the Zacks Rank #4 (Sell), including Banco Santander, S.A. (SAN), Bancolombia S.A. (CIB), Bank of Montreal (BMO), The Bank of Nova Scotia (BNS), ICICI Bank Ltd. (IBN) and KB Financial Group, Inc. (KB).

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