Foreign Banks: Geopolitics, Regulations Cloud Prospects

Weaker-than-expected global recovery, persistent geopolitical uncertainties and increasing risk taking by many countries compelled the International Monetary Fund (:IMF) to downgrade its global economic growth forecasts for 2014 and 2015. This is expected to significantly weigh on banks worldwide. This aside, fiscal policy gridlock and ever-increasing regulatory restrictions would soften the industry’s upturn, if not pause it, going forward.

Further, concerns of the Eurozone entering a triple-dip recession with a slowing rate of exports and a sudden decline in industrial output in Germany, along with the existing issues in China, Japan, Russia and Latin America are huge threats to the global financial markets.

While the state of the economy should heighten deflation worries, the requirement of keeping interest rates low is still deemed necessary by central banks, including the U.S. Federal Reserve, to support economic growth. This will continue to restrict the industry’s interest income.

Emerging markets such as China, Russia and Brazil are not left unscathed on the growth front. But the same remedial course by the central banks of these nations could pose a new set of challenges. Among others, any action to lower interest rates would elevate inflation issues. And the banks of these regions will have to bear the brunt.

On the other hand, not only are U.S. banks losing their luster with too many mandatory defensive measures, the non-U.S. banking space is also facing similar obstacles in their paths to growth.

Overall, the proactive steps taken by the central banks of most developed and emerging economies will continue to keep non-U.S. banks afloat in the near term. But the global financial system is yet to tidy up to secure the backdrop for banks.

Fundamental Issues

Repositioning of business fundamentals to withstand any further crisis remains the trend among non-U.S. banks. Though defensive actions like limiting expenses are still in place and focus on noninterest income is increasing, margin compression and slothful loan growth are the major dampeners.

Capital efficiency is the key to survival, and most foreign banks are adopting reconstruction-by-asset-sale strategies to strengthen capital ratios. While this will make their business safer, growth prospects are unimpressive with thinning sources of income.

Top-line Growth Remains Strained

A prolonged low interest rate environment in developed nations is not expected to reverse anytime soon as central banks of these economies will continue to prioritize growth. This strategy looks sustainable as increasing rates to control inflation is required only for a few emerging economies. These economies have started witnessing a sluggish growth rate, but dominating inflation concerns will force their central banks to keep interest rates higher than in low-inflation economies.

For any economy, low but positive inflation is desirable as it protects the purchasing power of consumers, keeps borrowing costs low, thereby creating a favorable business backdrop.

Given the current condition, banks operating in a low interest rate environment will not be able boost revenue through interest income. At the same time, non-interest revenue sources will be limited by regulatory restrictions.

On the other hand, banks in consumption-driven economies will not face significant challenges related to interest income due to a not-too-low interest rate environment. However, these banks will have no respite from nagging non-interest revenue challenges. Also, high competition from domestic and foreign players, and the downside of loose monetary policy will continue to hinder revenue generation.

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 pending implementation across jurisdictions. Continued attempts by regulators worldwide to agree on strict capital standards and clip the excessive risk-taking attitude of banks and 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 have yet to make headway.

Nonetheless, strict lending limits as well as greater transparency in regulations could strengthen fundamentals of many sector participants. Eventually, these are expected to create a less risky lane for the overall industry.

What Fed Rules for Foreign Banks Mean

The Federal Reserve’s stricter capital rules for foreign banking organizations (FBOs) sizably operating in the U.S. could cripple their balance sheet. According to the new rules, the U.S. operations of foreign banks need to hold risk-based capital, liquidity and leverage similar to their U.S. peers with effect from July 1, 2016.

This will force foreign banks such as Deutsche Bank AG (DB), HSBC Holdings (HSBC), Barclays PLC (BCS), Bank of Montreal (BMO) and Royal Bank of Scotland (RBS) to transfer costly capital from their home ground to the U.S. So their overall profitability could suffer as they need to spend more on the same business in the U.S.

But for low-margin businesses like repo and securities lending, in particular, transferring capital and liquidity to U.S. operations will not be beneficial for FBOs. Given this concern, some of the foreign banks have already planned to trim their U.S. balance sheets. Others could also follow suit by axing their low-margin U.S. businesses.

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 the performance 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 not be restricted to simply obedience to regulatory requirements.

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

Foreign Banks to Stay Away From

Given the concerns surrounding the foreign banking space, it would be prudent to stay away from industry players that have not been able to win analyst confidence with their activities. The following stocks have been witnessing downward estimate revisions and thus carry an unfavorable Zacks Rank:

Currently, Zacks Rank #5 (Strong Sell) stocks in our foreign bank universe are Credit Suisse Group AG (CS), Deutsche Bank AG, National Australia Bank Ltd. (NABZY) and UBS AG (UBS).

Zacks Rank #4 (Sell) stocks from the same universe include Banco de Chile (BCH), CorpBanca (BCA), HDFC Bank Ltd. (HDB) and BNP Paribas SA (BNPQY).

Investment Opportunities

While the near-term prospects of the industry do not look promising, it might be a good time for long-term investors to bet on a few large and fundamentally strong foreign banks that make analysts hopeful. It is now time to get these at a discounted price. Here are a few stocks that have been witnessing positive estimate revisions and carry a favorable Zacks Rank:

Currently, our foreign bank universe includes just one stock -- Erste Group Bank AG (EBKDY) -- that holds a Zacks Rank #1 (Strong Buy).

The stocks carrying Zacks Rank #2 (Buy) include HSBC Holdings, Royal Bank of Canada (RY) and Bank of Montreal.

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CORPBANCA -ADR (BCA): Free Stock Analysis Report
BANCO DE CHILE (BCH): Free Stock Analysis Report
BARCLAY PLC-ADR (BCS): Free Stock Analysis Report
BANK MONTREAL (BMO): Free Stock Analysis Report
BNP PARIBAS-ADR (BNPQY): Free Stock Analysis Report
DEUTSCHE BK AG (DB): Free Stock Analysis Report
ERSTE GROUP BNK (EBKDY): Free Stock Analysis Report
HDFC BANK LTD (HDB): Free Stock Analysis Report
HSBC HOLDINGS (HSBC): Free Stock Analysis Report
NATL AUS BK LTD (NABZY): Free Stock Analysis Report
ROYAL BK SC-ADR (RBS): Free Stock Analysis Report
ROYAL BANK CDA (RY): Free Stock Analysis Report
CREDIT SUISSE (CS): Free Stock Analysis Report
UBS AG (UBS): Free Stock Analysis Report


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