U.S. banks are starting to look a lot better as the risk of yet another economic slump has gradually abated and the ability to endure pressures from the operating environment has improved. Adding to these are the tailwinds from sustained GDP growth and reduction in unemployment.

Further, although the prevailing low interest rate environment curbs net interest margin – banks’ key source of earnings – it will continue to act as a key performance driver for some time. Asset quality, one of the most important performance indicators, will in particular keep building up on the back of low interest rates, which are expected to prevail at least till mid 2015.

Looking at fundamentals, cost containment and balance sheet recovery hold the key to the banks’ success. While cost containment can be perceived as a defensive measure, balance sheet recovery should help banks prosper.

Balance Sheet Recovery Underway  

Lack of low-risk investment opportunities has been continuing to aid deposit growth. Also, demand for loans has been increasing with recovering economic conditions and banks’ efforts to ease lending standards. Moreover, improvement in GDP, employment and other economic indicators have been helping banks strengthen their balance sheets, but reversal of interest rate environment will result in unrealized losses on underlying securities.

However, banks are trying to reorganize risk management practices to address potential solvency issues from rising interest rates. Asset-quality troubles are also being addressed by divesting nonperforming assets. Yet, we don't expect balance-sheet strength to return to the pre-recession peak any time soon.

"Problem Banks List" Shortens, but Not Reasonable Yet
 
The FDIC's "Problem List" contained 329 names as of Sep 30, 2014, down from 354 as of Jun 30, 2014. This is the lowest level since 305 in the first quarter of 2009 and represents a 63% decline from the post-crisis high of 888 as of Mar 31, 2011. This reflects improvement no doubt, but the number looks extremely high considering the occurrence of the financial crisis six years back. There were only 76 banks on the Problem List at the end of 2007, just before the crisis.

Considering the recovery witnessed by the economy and stock markets so far, the number of problem banks ought to have been much less. This indicates that the industry is still fraught with trouble.

However, 14 banks failed during first nine months of 2014 compared with 22 failures in the same period last year. Total 24 banks failed in 2013 (versus 51 in 2012 and 92 in 2011) and a lesser number is expected in 2014. Though the pace of bank failures has been decelerating, the industry is still to see an average failure of just four or five banks annually, which would indicate its maximum strength.

"Too-Big-To-Fail" Notion About to End

Mega banks have been benefiting from lower funding and operating costs since the financial crisis six years ago. This is because of the impression that the Federal Reserve will always protect these banks from failing in case of any major financial trouble.

However, the advantages have been waning in recent years. The regulatory changes, in particular the 2010 Dodd-Frank law, made these systematically important banks self-sufficient (in terms of capital reserves) to some extent to endure any further crisis. So the likelihood of a bailout is less now.

Further, a new set of rules put forth by the Financial Stability Board (FSB), expected to take effect in 2019 following the G2O leaders’ endorsement, would make the "too big to fail" notion a thing of the past. The rules would require the world’s 30 so-called "systemically important" banks to hold up to one fifth of their risk-weighted assets in the form of debt or equity. This buffer would help bolster these banks in case of any risk of failure.

Though the biggest banks will continue to enjoy low borrowing costs and take bigger risks until these rules are implemented, the advantages should wane with time.

Stocks Worth Betting On Now

As you can see, there are plenty of reasons to be optimistic about the U.S. banking industry now. So one may consider buying some bank stocks that promise better performance based on their strong fundamentals and a favorable Zacks Rank.

Specific banks that we like with a Zacks Rank #1 (Strong Buy) include Baylake Corp. (BYLK), Enterprise Financial Services Corp. (EFSC - Snapshot Report), Oritani Financial Corp. (ORIT - Snapshot Report), S&T Bancorp Inc. (STBA - Snapshot Report), Fidelity Southern Corporation (LION - Snapshot Report), Investar Holding Corporation (ISTR) and Western Alliance Bancorporation (WAL).

Stocks in our U.S. banking universe with a Zacks Rank #2 (Buy) currently include State Street Corporation (STT - Analyst Report), Associated Banc-Corp (ASBC - Analyst Report), Horizon Bancorp (HBNC - Snapshot Report), Cullen/Frost Bankers, Inc. (CFR - Analyst Report) and FCB Financial Holdings, Inc. (FCB - Snapshot Report).

Check out our latest U.S. Banks Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy.