It’s common knowledge that financial companies thrive in a rising interest rate environment. Therefore, U.S. banks will undoubtedly get a boost from the impending rate hike by the Federal Reserve. This, along with the fundamental strength earned by banks since the last financial crisis, should help them reach the turning point of consistent growth.

The likely interest rates hike, though at a slower pace, will ease some pressure on net interest margin (NIM) – a key source of banks’ earnings. Also, banks will earn more from the money that they need to keep at the Fed compared with almost no income from this source in a near-zero rate environment that has prevailed since the last financial meltdown.  

  On the other hand, aggressive actions have paired up with defensive measures like expense control to make banks win over persistent challenges. Moreover, banks have earned the ability to deal with crises. They can now dodge pressures from the operating environment more easily.

In terms of fundamentals, along with strategic changes in the business model and a deeper focus on boosting profitability, balance sheet recovery and expense management hold the keys to success.

(Check out our latest U.S. Banks Stock Outlook for a more detailed discussion on the fundamental trends and the position of this important sector from an earnings perspective.)

Deeper Focus on Balance Sheet Right-Sizing

The lack of low-risk investment opportunities for Americans has so far aided banks in significantly growing deposits. In fact, banks have so much excess deposits now that they don’t have to competitively increase rate to attract new deposits for quite some time.

So an expected slowdown in deposits in the near term with increased investment opportunities for Americans in a higher rate environment should not be a problem. However, banks should focus on customer relationships and invest in products that will make the deposit base stable in the long run.  

Also, demand for loans from consumers and commercial borrowers is on the rise with recovering economic conditions and easier lending standards.

Moreover, improvements in GDP, employment and other economic indicators have been boosting the balance sheets of banks. But the upcoming change in the 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 segments containing nonperforming assets. Yet we don't expect balance-sheet strength to return to the pre-recession peak anytime soon.

FDIC’s "Problem List" Continues to Shrink
 
The third quarter of 2015 marked the 18th straight quarter of decline in the FDIC's "Problem List." The list contained 203 names as of Sep 30, 2015, down from 228 as of Jun 30, 2015. In fact, this is the lowest level since the end of 2008 and represents a 77% decline from the post-crisis high of 888 as of Mar 31, 2011.

This undoubtedly reflects improvement, but the number is still high considering the occurrence of the financial crisis nearly seven 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, the number of bank failures has declined every year since 2010. In 2014, 18 banks in total failed compared with 24 failures in 2013 (versus 51 in 2012, 92 in 2011 and 157 in 2010). In 2015, 8 banks have failed so far. Though the pace of bank failures has been decelerating, the industry has yet to see an average failure of just four or five banks annually, which would indicate maximum strength.

Major Banks to Shoulder Risk of Failure

Regulatory changes, in particular the 2010 Dodd-Frank law, made 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 now reduced.

Earlier this year, a proposal by the Fed required the large banks to add another buffer to make them more capable of dealing with any future crisis and correct their "too big to fail" perception. In order to meet the requirements, 6 of the 8 key U.S. banks would need to raise $120 billion, per Fed officials.

Further, a new set of rules put forth by the Financial Stability Board (FSB - Snapshot Report) would make the "too big to fail" notion a thing of the past. The rules would require each of the world’s 30 so-called "systemically important" banks to have total loss absorbing capacity of 16% of total assets by 2019 and 18% by 2022. This would act as a buffer should any of these banks run the risk of failure.
 
Though the biggest banks will continue to enjoy low borrowing costs and take bigger risks until these rules are effective, the advantages should wane with time. This will actually make the competitive landscape better for small and mid-cap banks.

Banks Resorting to Analytics for Competitive Advantage

Along with the adoption of advanced technologies to enhance cyber security, banks are resorting to increased use of analytics to drive efficiency. This could help them to better formulate strategies and enhance the performance of different business segments.

Stocks Worth Betting On Now

As you can see, there are plenty of reasons to be optimistic on the U.S. banking industry now. So one can 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 American River Bankshares (AMRB - Snapshot Report), Franklin Financial Network, Inc. (FSB - Snapshot Report), Blue Hills Bancorp, Inc. (BHBK - Snapshot Report) and German American Bancorp Inc. (GABC - Snapshot Report). 
 
Stocks in our U.S. banking universe with a Zacks Rank #2 (Buy) currently include BofI Holding, Inc. (BOFI - Snapshot Report), CommunityOne Bancorp (COB - Snapshot Report), County Bancorp, Inc. (ICBK - Snapshot Report) and BOK Financial Corp. (BOKF - Analyst Report).