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5 Regional Banks to Watch Heading Into Earnings (Update 2)

Updated from 9:54 a.m. ET with a downgrade of SunTrust and comment from Credit Suisse analyst Craig Siegenthaler, along with comment on PNC and a price target increase from Deutsche Bank analyst Matt O'Connor.

NEW YORK ( TheStreet) -- Heading into first-quarter earnings season, efficiency is the name of the game for big U.S. banks.

Most large banks are continuing to see their net interest income pressured in the prolonged low-rate environment. With the short-term federal funds rate staying in a range of zero to 0.25% since late 2008, most of the big players have already realized the benefits on the cost side. Meanwhile, higher-rate residential mortgage loans continue to be refinanced and commercial loans continue to reprice at lower rates. The FDIC reported the aggregate net interest margin for U.S. banks narrowed to 3.32% in the fourth quarter from 3.43% in the third quarter and 3.57% in the fourth quarter of 2011.

There has been upward pressure in the market on long-term rates, anticipating the eventual change in the Federal Reserve's policy of holding down rates through large monthly purchases of long-term securities. Market rates on 10-year U.S. Treasury securities during the first quarter ranged from 1.84% to 2.07%, increasing from a range of 1.58% to 186% in the fourth quarter. But Deutsche Bank analyst Matt O'Connor on March 22 said in a report that banks net interest margins "are likely to remain under pressure from continued low absolute rates and likely increasing loan pricing pressure."

According to the Federal Reserve, average loans for U.S. banks increased by 2% through March 22, from the fourth quarter. The growth rate was down from 4% in the fourth quarter. Jefferies analyst Ken Usdin on Monday said in a report, "on the mortgage banking front, the drivers of fees are starting to weaken with both average mortgage applications (down 4% Q-Q) and average gain-on-sale margins (down 13%) compressing. We expect total origination volume to decline throughout the year as the refi fall-off outpaces the purchase pick-up."

While some smaller regional lenders are seeing increasing commercial loan demand, it would appear that most banks will continue to focus on making their operations leaner, in order to wring every last bit of expense savings.

At this stage of the credit recovery, many banks continue to bear outsized expense levels as the work through problem loans and repossessed real estate. The unfortunate aspect of improvements in these areas is a wave of staff layoffs, which will continue until the banks feel the need to add production staff.

A bank's efficiency ratio is, essentially, the number of pennies of expenses it incurs for each dollar of revenue. It's not surprising to see banks with the greatest credit overhang having the highest (worst) efficiency ratios; investors can expect plenty of discussion on efficiency ratios and cost cutting during first-quarter earnings calls.

According to data provided by Thomson Reuters Bank Insight, Bank of America (BAC - Get Report) had a 2012 efficiency ratio of 84.11% in 2012, improving slightly from 84.52 in 2011. This was the highest efficiency ratio among the 24 components of the KBW Bank Index (I:BKX), which is hardly surprising, since Bank of America, through its ill-timed acquisition of Countrywide Financial in 2008, has, by far the greatest number of problem mortgage loans, repossessed properties, and repurchase demands from investors to deal with.

Among major regional players, U.S. Bancorp (USB - Get Report) of Minneapolis had the best efficiency ratio of 52.07% in 2012, improving slightly from 52.40% in 2011. The company's excellent efficiency ratio is reflected in its very strong earnings performance, with a 2012 operating return on average assets (ROA) of 1.65% and return on average tangible common equity of 20.80%, according to Thomson Reuters Bank Insight.
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