NEW YORK ( TheStreet) -- As the new year swiftly approaches, the banking sector is facing a lot of "what if" scenarios. For many banks and their investors, the most important unknown is how, when and where they will be able to make loans in order to turn a profit.
Recently, bank executives have been expressing increasing optimism on the lending front, particularly with commercial and industrial (C&I) loans, as corporations cautiously put their toes in the water. This is positive news given the sluggish pace of economic recovery and the transformational changes making it harder for banks to earn money as a result of the financial crisis. "Banks need to make loans; bottom line," says Michael Rose, vice president of equity research at Raymond James & Associates. But given the economic uncertainty, the big question is -- "are customers going to need to borrow? We've all read that corporations are flush with cash and they can draw down that first before they need to go out and borrow at least on the loan basis." Rose continues: "Banks are trying to make loans, but remember particularly in the Southeast, the banks still have credit headwinds to deal with. They're not out of the woods yet. Things are getting better... but loan balances
are pressured." So what if lending doesn't pick up next year? Banks will not always be able to rely on improving credit costs and reserve releases to boost earnings. Loans are the backbone of any institution -- large or small -- as a significant portion of a bank's business is interest income. Industry observers are predicting marginal loan growth in 2011, which will not bode well for banks that are in desperate need of revenue. With that said, true revenue growth at the banks - and with that investor confidence -- will remain stagnant until loan growth picks up, particularly for regional banks. The smaller banks have fewer levers to pull as opposed to the large and multinational banks in terms of business diversification. They are also still battling credit headaches in asset classes like residential housing, construction and commercial real estate. To be sure the big banks are still dealing with problem loans as well but are able to offset it better.
Keefe Bruyette & Woods expects overall bank operating revenue growth next year to fall 1%, given limited loan demand and a challenging yield curve environment. The limited loan growth is driven by "further consumer de-leveraging and low levels of line utilization from businesses" not to mention rep and warranty risk that could stifle banks from making loans at least in the near term, KBW analysts write in a note on Thursday. Total loans for the industry fell by 8%, according to KBW. Adjusted for loans that returned to the balance sheet related to FAS 166/167, the decline was even more pronounced at 12% (excluding consumer loans), the note said. "That said, we do believe several banks are well positioned to not only benefit from a pickup in economic activity (through higher line utilization rates), but also from incremental market share gains, such as JPMorgan Chase ( JPM), U.S. Bancorp ( USB) and Wells Fargo ( WFC). In addition, a general rebound in C&I activity should favor companies like Comerica ( CMA). PNC Financial Services ( PNC) is likely to gain further traction in asset-based lending that will partially offset the continued run off of legacy National City loans, the note says. KBW believes stocks like JPMorgan, PNC, U.S. Bancorp and Wells Fargo will outperform peers given that they are also are in a position to return capital to shareholders, priced at a discount to the group based on near-term earnings forecast, have diversified revenues, and are expected to earn in excess of its cost of equity, the note says. Raymond James' Rose also points to the C&I rebound as the differentiator of banks that will likely show loan growth next year. "We believe it is one of the few areas in which banks have an opportunity to experience growth in their loan portfolios in the nearer-term. Indeed, banks that have a core competency in this line of business, or have made strides in boosting capacity in the segment, are best positioned to experience growth versus peers," according to a group industry note from September 26. Rose prefers banks that have heavy C&I exposure, are in stable geographies and are gaining market share from competitors.
Aside from Comerica, which is Rose's top pick currently among the largest banks he covers, BB&T ( BBT), M&T Bank ( MTB), New York Community Bancorp ( NYB), U.S. Bank and PNC are poised to benefit from this initial C&I rebound. Comerica is "well-positioned" given its roughly 50% concentration of C&I loans in its portfolio as well as the increasing contribution from better performing geographies in Texas and California, according to the Raymond James note. U.S. Bank has roughly 18% of its portfolio in C&I loans, but is also poised to grow its C&I portfolio due to its market presence in higher-growth western markets, particularly California, the note says. BB&T (13% C&I concentration) "continues to make strides in the C&I segment and is well-positioned to do so given its strong capital base and enhanced market footprint following its FDIC-assisted acquisition of Colonial in August 2009." Raymond James says. Once there is more clarity surrounding banks' reps and warranties issues, banks will be more likely to make loans. "It will be easier for banks to price that risk," says Frank Germack, director of investments at Rehmann Financial. "If banks are found to be increasingly liable for these reps and warranties, even if they didn't originate the loan, it would be pretty clear that they would tighten up the standards dramatically and force the portfolio down." -- Written by Laurie Kulikowski in New York. To contact the writer of this article, click here: Laurie Kulikowski. To submit a news tip, send an email to: firstname.lastname@example.org.