The expected benefits from rising interest rates and reforms proposed by the Trump administration might give bank stocks a solid boost, but investors’ enthusiasm may wane if the hype over the upside finally proves wrong. That’s because, the optimism over these two factors has already propelled bank stocks substantially higher.

While there is no indication of disruption in the interest rates moving higher, the Trump administration is yet to make any tangible progress on the reforms front. As political oppositions reduce chances of a full-scale regulatory reform, only smaller adjustments appear feasible. While any adjustments to existing regulations would be favorable for banking business, they may fail to meet investors’ expectations that have already been priced in.

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 policy changes, 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 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.

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. However, expense reduction may not be a major support going forward, as banks have already cut the majority of unnecessary expenses.

Banks’ proactive actions to move beyond defensive steps, such as cost containment, were also effective in staying afloat over the last few quarters. Yet these are 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.

While results for the last few quarters show some respite from high legal costs, higher spending on cyber security, technology, analytics and alternative business opportunities will cost a pretty penny.

In an earlier piece (U.S. Banks Poised to Thrive Even Without Deregulation), 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.

Rate Hike Benefit May Not Meet Expectations

In order to survive in the prolonged low interest rate environment, banks have reduced their dependence on rate-sensitive revenues and focused 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 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.

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, capital buffers that U.S. banks have been forced to maintain so far might not be enough to fight 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 Sufficient

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 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 has been the tactic.

Also, the way of generating earnings seems a stopgap. While there is limited scope to reduce expenses further, lowering provisions may not last long. 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 not be consistent.

Stocks to Dump Now

Despite the expected benefits from the reforms and rising interest rates, there are a number of reasons to worry about the industry’s performance in the near 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.

Here are a few stocks that you should stay away from:

Prosperity Bancshares (PB Quick QuotePB - Free Report) : This Zacks Rank #4 (Sell) stock lost about 10% over the last six months versus the S&P 500’s gain of 8.5%. The stock’s earnings estimates for the current fiscal year have been revised marginally downward over the last 60 days.

Great Western Bancorp : A downward revision in earnings estimates for the current fiscal year over the last 60 days precipitated a Zacks Rank #4 for this stock. The stock lost more than 5% in the last six months.

Bank of the Ozarks : This Zacks Rank #4 stock lost 7.7% over the last six months. The stock’s earnings estimates for the current fiscal year have been revised 2.3% downward over the last 60 days.

First Horizon National Corp. (FHN Quick QuoteFHN - Free Report) : Roughly 1% downward revision in earnings estimates for the current fiscal year over the last 60 days precipitated a Zacks Rank #4 for this stock. The stock lost 9.4% in the last six months.

(Check out our latest U.S. Banks Stock Outlook for a more detailed discussion on the fundamental trends.)

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