Why Buying U.S. Bank Stocks Could Disappoint

U.S. banks are trying every means to contain costs, either through closing lackluster operations or by laying off personnel. Yet increased legal expenses, higher spending on cyber security and alternative business opportunities are costing a pretty penny. Added to these is dull top-line growth that is hurting profits.  

A dearth of overall loan growth and consequent pressure on net interest margin remains prominent with liquidity coverage rule (LCR) requirements and intense competition. Though the likely interest rate hike later this year should offset some pressure, there will be no significant changes on the net interest margin front given the Fed’s plan to raise rates at a slower pace.

In an earlier piece (U.S. Bank Stocks with Growth Potential), we provided the favorable arguments for investing in the U.S. banks space. But we would like to argue the opposite case in this piece to help you make the right call.

What the Interest Rate Hike Effectively Means for Banks
    
Banks will benefit from rising interest rates only if the increase in long-term rates is 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 will charge for loans (typically tied to long-term rates). This opposite case will actually hurt net interest margin.

On the other hand, continued improvement in the labor market and economy would lead to a rate hike, so credit quality — an important performance indicators for banks — should improve if interest rate increases. However, the prolonged low interest rate environment has forced banks to ease underwriting standards so far. This, in turn, has increased the chance of higher credit costs.

Further, shifting assets to longer maturities — the only way to reduce pressure on net interest margin — doesn’t look appropriate now, as the expected increase in interest rates later this year could backfire.

Will Capital Buffer be Sufficient to Absorb 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, the capital buffers that U.S. banks are forced to maintain might not be enough to fight the risks of default.

Strengthening Revenue Will Not Be Easy