This is a continuation of yesterday’s post on the outlook in the banking sector. Two years ago, I said that net interest margins at banks would get crushed by the Fed’s keeping interest rates low because it would cause the yield curve to flatten and diminish net interest margins. This has turned out to be true, particularly at regional banks that are more pure play banking franchises without significant investment banking or securities businesses.
Credit Suisse sees no upside in regional bank stocks as a result. Barron’s recently wrote that the intermediate EPS outlook at regional banks was negative not just on net interest margins but also on loan growth. Moreover, the regional bank stocks are trading as a sector at a relatively high forward 2014 P/E of 10.2 times earnings despite the fact that they have poor organic growth prospects due to the slowing in loan growth and the decline in net interest margins.
Warren Buffett’s comments from earlier in the day on CNBC highlight the problem. In the wake of the financial crisis, banks are expected to hold more capital to reduce leverage. And unless banks can earn higher returns on assets, this lower leverage will translate into lower return on equity. Buffett mentioned his favourite two pure play bank stocks Wells Fargo and US Bancorp as companies whose business models he still supports. I like US Bancorp a lot more than Wells Fargo though.
Also note that Buffett said in his CNBC interview that European banks were still highly leveraged in comparison to US banks and suggested this would be the case for some time. My own view is that European politicians are not keen to do any heavy lifting on bank recapitalization that involves government money because doing so would increase debt and deficit numbers during a period of austerity and a sovereign debt crisis. This means that European banks will have to get funding from private sources and will indeed remain over-levered for some time to come. Moreover, European banks naturally carry a lot more assets on their balance sheet than US banks due because the securitisation market is smaller and there has been less bank disintermediation despite best efforts by big European to unload traditional bank loan risk into the securitisation market.
In my view, the banking sector is a sector that is unusually fraught with risk at this juncture, particularly in Europe and amongst regional banks in the US. I believe the lack of organic growth opportunities in the US will lead to an increased pace of mergers and acquisition amongst regional banks in order to boost return on equity via economies of scale. In Europe, the focus will be in shedding assets and raising capital. But earnings growth will be weak or negative.