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What If Trump’s Policies Aren’t Bullish For Banks After All?

From Zacks: There are enough reasons for banks and their investors to cheer, as President Trump’s policy goals appear to open a number of avenues for profitability. Among others, the expected roll back of the Dodd-Frank Act, which has been limiting banks’ business flexibility, could come as a big support.

But investor optimism may not last if the potential political upside finally proves to be an overestimation, even if Trump lives up to his promises.

Moreover, softer regulations might benefit banks’ earnings mostly from domestic operations. However, larger banks with significant international exposure might lose out on competitiveness due to ever-increasing international regulatory standards. Further, meeting international standards will restrict them from generating domestic revenues.

Though it is too early to make any negative assessment of the likely financial policies, easier lending standards and lesser regulatory restrictions could increase credit costs for banks, similar to what the industry witnessed just before the recession.

Moreover, while the expected speedup of rate hikes and Trump’s pro-growth and business-friendly approach will instill some fresh energy into the banking business, there are a number of fundamental challenges to hold banks back from growing steadily.

Improvement in net interest margins – the difference between deposit rates and lending rates – is not expected to be robust in 2017. This is because the other two expected rounds of rate hike by the Fed are unlikely to take the interest rates near historical standards.

Other nagging factors – including exposure to the still-struggling energy sector, continued commodity price recession and global economic growth concerns – are also likely to dull the prospects of U.S. banks.

While the earnings performance of U.S. banks was not discouraging in the past few quarters, this was mainly attributable to the temporary defensive measures that they adopted to tide over legacy as well as new challenges.

Slowing loan growth over the last few months despite eased lending standards remains a concern. Since Nov 2016, commercial banks have seen the weakest loan growth in five years, per the Fed’s latest data. While growth in consumer loans remained strong, commercial and industrial credit growth shrank significantly.

Banks’ proactive actions to move beyond defensive actions – like cost containment and enhancing alternative revenue sources – have supported results over the last few quarters. Yet these were not enough to make the growth path steady, as emerging issues like cybercrime and unconventional competition (from fintech and other technology firms) are piling up.

Banks are trying every means to contain costs, either by closing lackluster operations or by laying off personnel. Yet higher spending on cyber security, technology, analytics and alternative business opportunities will cost a pretty penny.

In an earlier piece (Reasons Other than Trump and Fed for U.S. Banks to Cheer), we provided arguments in favor of investing in the U.S. banks’ space. But here we would like to discuss some points that substantiate the opposite case.

Interest Rate Hike May Not Turn Out as Positive as Expected

In order to survive in the prolonged low interest rate environment, banks have reduced their dependence on rate-sensitive revenues and are focusing more on alternative revenue sources. So, rising rates may not immediately benefit banks as much as they did in the pre-crisis period.

On the other hand, with interest rates rising, banks will benefit only if the increase in long-term rates are 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). The opposite case would 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 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 from loans.

Further, credit quality – an important performance indicator for banks – may not improve with an interest rate hike if there is lesser regulatory supervision. The prolonged low interest rate environment has already forced banks to ease underwriting standards, which, in turn, has increased the odds of higher credit costs.

Banks’ Capital Level Could Fall Short in Absorbing Future Losses

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, capital buffers that U.S. banks are forced to maintain might not be enough to fight the risks of a default. Likely lesser restriction on capital under the Trump administration would make dealing with a default even more difficult.

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 earnings. On the other hand, prohibiting drillers from their loan portfolio could end up doing more damage, as it would reduce the chance of repayment of the moneys they have already lent.

Non-Interest Revenues Are Not Dependable

Banks’ strategies to generate more revenues from non-interest sources are working well, but the sources are not yet dependable. 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.

Deteriorating Quality of Earnings

Banks have been delivering better-than-expected earnings for quite some time now, but the positive surprises have mostly been backed by conservative estimates. Promising low and then impressing the market with an earnings beat is the name of the game.

Also, the way of generating earnings seems a stopgap. Measures like forceful cost reduction and lowering provisions 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 provisions.

Unless the key business segments revitalize and generate revenues that could more than offset the usual growth in costs, bottom-line growth will simply not be consistent.

The Financial Select Sector SPDR Fund (NYSE:XLF) closed at $23.54 on Friday, down $-0.03 (-0.13%). Year-to-date, XLF has gained 1.25%, versus a 4.62% rise in the benchmark S&P 500 index during the same period.

XLF currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 38 ETFs in the Financial Equities ETFs category.

This article is brought to you courtesy of Zacks Research.

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