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

Banks’ efforts to strengthen top line by focusing more on non-interest income have not been working effectively. 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.

Further, greater propensity to invest in alternative revenue sources on the back of an improved employment scenario might result in higher non-interest income. But grabbing good opportunities will require higher overhead.
 
Earnings: Under-Promise and Over-Deliver
 
Better-than-expected earnings have been the key drivers of banks’ performance in the last few quarters, but primarily conservative estimates led to the surprises. Promising low and then impressing the market with an earnings beat has become a trend.

Also, the way of generating earnings seems a stopgap. Measures like forceful cost reduction and lowering provision may not last long as earnings drivers. Continued narrowing of the gap between loss provisions and charge-offs will not allow banks to support the bottom line by lowering provision.

Further, competing with other industry participants to grab new business opportunities would require significant spending which in turn would increase costs.

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 Stay Away From or Dump Now

While the financials of banks have no doubt improved over the last few years, there are still a number of reasons to worry about the industry’s performance going forward. So it would be prudent to get rid of or stay away from some bank stocks that depict weak fundamentals and carry an unfavorable Zacks Rank.

We don't recommend Peoples Bancorp Inc. (PEBO - Snapshot Report) as it carries a Zacks Rank #5 (Strong Sell).

We also don’t recommend stocks with Zacks Rank #4 (Sell) including Bank of America Corp. (BAC - Analyst Report), Trustmark Corp. (TRMK - Snapshot Report), Old National Bancorp. (ONB - Snapshot Report) and TriCo Bancshares (TCBK - 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.