Despite Financial Reform, Banking Industry Set for Strong Rebound

Buckle up, bank investors: The next 48 hours will determine just how hard financial reform hits banking companies.

In Washington, key elements of the debate remain in play. The final shape of a plan to rein in Wall Street’s use of derivatives is unclear, although Rep. Barney Frank has pledged to preserve the “essence” of the measure. Financial firms are making progress softening the Volcker Rule, which as originally drafted would ban proprietary trading and force banks to dump their hedge and private equity funds. Regulations on debit cards are set to tighten. An amendment introduced by Sen. Susan Collins, R-Maine, aimed at boosting capital standards would take a bite out of institutions that rely on so-called trust preferred securities to pad their reserves.

Another critical, but often neglected, consideration is where Congress draws the line between federal and state regulatory authority, given the arbitrage opportunities. In Europe, meanwhile, the G-20 are teeing up new bank taxes.

In short, round and round she goes. The only certainty for now is that the potential impact of financial reform is throwing a deep, dark shadow over bank stocks, as shown by the recent dip in the KBW Bank Index. The new legislation could slash up to 23 percent and 18 percent off Goldman Sachs’s (NYSE: GS) and JPMorgan Chase’s (NYSE: JPM) earnings, respectively, Citigroup (NYSE: C) analysts recently projected. Bank of America (NYSE: BAC), the largest U.S. financial institution, could see profits tumble by 16 percent. Said Sandler O’Neill analysts in a recent research note commenting on proposed limits on swaps trading:

We believe that a forced exit of bank dealers from the derivatives market could have severe unintended consequences ranging from an overall capital markets market share shift to non-U.S. firms, to significantly higher hedging costs for U.S.-based manufacturing firms and less credit extension by larger banks.

I love the smell of napalm in the morning. Of course, financial reform isn’t the only factor clouding bank prospects. Job creation remains anemic, which dampens consumer demand for loans and accelerates foreclosure-related losses, among other effects. Home prices continue to stagnate, while commercial real estate is a ticking bomb (click on chart to expand).

Indeed, the operating environment for banks remains very tough. Although many banks are seeing margins rise, that’s mostly due to the firms’ inordinately low borrowing costs, courtesy of Uncle Sam. Tighter underwriting standards also are making it harder to find creditworthy borrowers.

Here’s the thing: Hope lives. For all the anxiety about where the banking sector is headed, the industry is unquestionably on the mend. First-quarter earnings reached $18 billion, a large jump over the year-ago figure and the highest quarterly total since the first quarter of 2008. Sure, most of the growth was concentrated among big institutions, but more than half of commercial banks and thrifts reported a lift in net income, driven largely by reduced loan-loss provisions. While loan losses continue to grow, credit conditions are stabilizing. On Wall Street, equity underwriting is starting to grow.

Are the bulls pawing the ground? Not quite. Historically, however, investors who own bank stocks following recessions have fared well as the economy and capital markets healed. For now, headline risk is casting a pall. But those headlines will change as industry earnings continue to recover and financial players adapt to the new regulatory landscape.

Specific firms also stand to prosper. For all the focus on the SEC’s lawsuit against Goldman, over the years the investment bank has proved itself highly adaptable to new financial and market conditions. Don’t bet against the squid.

Another Wall Street firm that looks set to flourish is Wells Fargo (NYSE: WFC). At the California giant’s May investor conference, execs cited opportunities to boost market share and cross-selling opportunities in targeting 10 percent revenue growth, with return-on-assets of 1.5 percent. Loan losses also look to have peaked, and Wells is starting to see dividends from its $15.1 billion purchase of Wachovia in 2008.

Meanwhile, for all the angst on Wall Street about reform, the era of “too big to fail” will carry on. Big banks have gotten bigger, with Congress — and the Obama administration — showing little appetite to cut them down to size.

Indeed, financial industry executives are increasingly optimistic. More than three-quarters of banking and financial services executives expect higher quarterly revenue and profitability in 2011, according to a poll out today by KPMG (no public link). As the chart at bottom indicates, they expect growth to be driven by checking, savings and other traditional banking services; credit cards; emerging technologies; M&A; and securities trading.

For now, it’s steady as she goes, as lawmakers put the finishing touches on legislation that will reshape, if not revolutionize, the financial industry. See you on the other side.

Image from Flickr user Gummi Stori

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