Banking Sector Becomes ‘Haves’ and ‘Have-Nots’

Although three reported bank failures in 2011 are below that of the same period last year, sector pundits expect the final tally over the coming 12 months will be similarly bleak.

The fact that stock markets took a nosedive on Wednesday after several banks produced dismal fourth-quarter earnings is a further sign that the banking sector is far from out of the woods. Wednesday’s trading alone saw about 2% shaved from the share prices of Goldman Sachs (NYSE:GS), Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM) and Visa (NYSE:V).

In its fourth-quarter commentary, Goldman Sachs attributed a 53% drop in earnings to a slowdown in trading and investment banking business. This sounds almost like a confession that the banking cart has lost its driver and no one is sure where and when the tight bends are coming.

Last year produced an almost record number of 157 bank failures (the highest level since the savings and loan crisis of the early 1990s), according to data from the Federal Deposit Insurance Corp. This compares with 140 bank closures in 2009 and 25 the year prior. Approximately 125 to 150 banks are likely going to be added to the FDIC’s failure list by the end of 2011, predicts Christie Sciacca, a director at economic advisory firm LECG Corp.

 He notes that the FDIC’s unpublished “problem bank list” still exceeds 700 entities, suggesting many of these banks are precariously close to joining the butcher’s bill. “I hope I’m wrong, and that things settle down [for the banks], but if the economic environment doesn’t improve noticeably, then I expect the number of failures will remain high.”

The sluggish economic recovery — particularly within the real-estate sectors — combined with questionable asset quality and continued bleeding from residential and commercial real-estate loan defaults remain challenges to growth for the banking sector, Sciacca observes. Plus, lending activity of the banks remains lean (specifically among the regional players), he adds, which will dampen top-line growth, while new legislative constraints fettered on the sector will place pressure on margins and dent the bottom line in terms of compliance costs.

The economic woes suffered by the banks since the credit crisis fallout in 2008 has seen the emergence of two camps within the banking sector, Sciacca says. “The larger players are slowly finding their way forward and are releasing loan loss reserves — they have benefited the most from the government financial aid programs while the smaller, regional banks are still constrained by their credit problems.”

In fact, Moody’s Investors Service expects the banking sector will face a wave of consolidation this year largely due to the new financial strength stress testing applied to banks. The rating agency believes that such regulatory overseeing will further differentiate the “haves” and “have-nots” in terms of which banks have repaid Troubled Asset Relief Program loans.

The “have-nots” — which Moody’s lists Fifth Third Bancorp (NASDAQ:FITB), KeyCorp (NYSE:KEY), SunTrust Banks (NYSE:STI) and Regional Financial (NYSE:RF) as examples — may look to sell rather than diminish returns on capital as a result of dilutive capital raises. According to Moody’s, “the current stress test and the resulting potential for dilutive capital raises may be a primary driver of consolidation among large regional banks, and could result in some institutions deciding to sell.”

Moody’s has maintained a negative credit outlook for the banking sector. “We believe the return to ‘normal’ level of credit conditions will be slow and uneven through the next 12 to 15 months.” In contrast, Fitch Ratings’ outlook for banks in 2011 remains stable. “Fitch expects that new inflows of problem credits will subside and that banks have largely reserved for the losses that remain.” Fitch also expects merger and acquisition activity within the banking sector will intensify this year, “as industry revenue challenges remain unabated and shareholder pressures increase”.

Brian Gendreau, market strategist at brokerage Financial Network Investment Corp., is somewhat more robust about the earnings growth prospects of the banks this year. “Almost all of the economic figures are coming in stronger than expected, and historically, the banks have recovered faster than expected — I think there is more potential for an upside surprise [regarding performance of the banks] than a downside surprise.”

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