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For Banks, Uncertainty Reigns

Questions surround the banking industry, but opportunities are out there for investors with a healthy tolerance for risk.

Philip Guziec, 10/18/2011

Banks have been on somewhat of a rollercoaster ride in the past couple of years, and there's little on the horizon to suggest that the ride is coming to an end anytime soon. I recently sat down with members of Morningstar's financial-services team to discuss where banks stand, and their message was clear: Amid uncertainty, look for banks with solid fundamentals.

Philip Guziec: What's the status of the ongoing saga with the global banking industry?

Jim Sinegal: Three major issues hang over the banking sector. The first is Europe. Everyone knows that the banks have a lot of bad assets to deal with, and we haven't seen a good solution to that problem. Second, a lot of macroeconomic concerns have come back in the past few weeks. What is GDP growth going to look like in the United States? What are the implications on credit growth for banks, and how does that affect their profitability going forward? Third is regulation. For the next year, at least, we are going to see a lot of new regulations finalized around Basel III and the Dodd-Frank Act. No one's sure exactly how that's going to turn out.

Guziec: In terms of regulation, what's the range of outcomes that you see for long-run banking earnings and valuations? If you see a healthy bank, how do you figure what the impact of regulation is going to be?

Sinegal: There are two ways to look at it. First is, what will the final regulations be? How much capital are banks going to be able to hold? Second is, how is that going to affect their profitability? Is decreasing leverage going to proportionately reduce profitability? Or are banks going to find ways to deal with that? In a lot of areas, banks are going to find ways to deal with it. You always see new fees, and we've seen a lot of that already. Banks have a lot of ways to deal with it, but the uncertainty has been an issue regardless. 

Guziec: So, your take is that one way or another we're going to get ROEs going forward that are comparable to what we saw over the past decade? What are we looking at?

Sinegal: Banking, at its heart, is a cost-of-capital, commodity-type business. So, on average, I think we're going to see cost-of-capital-type returns, and you could argue that the cost of capital will maybe go down a little bit with lower leverage. Some of the most-advantaged banks will still be able to deliver pretty good returns.

Guziec: How about the macro/GDP situation? You've got a short-term impact on banks. Do you think we're going to lose any more banks? How does that affect the long-run scenario?

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