After underperforming the sector and the markets in 2011, will large-cap banks make a comeback in 2012?
Much of it will depend upon whether the bigger banks can live up to their promise of higher dividends and buybacks, while proving to the Federal Reserve that they have enough capital to absorb losses from events as severe as the collapse of the euro to another big recession in the U.S.
Banks deemed "too big to fail" including Bank of America, JPMorgan Chase, Citigroup and Wells Fargo will also have to show that they are on track to meet the phase-in schedule for Basel III capital standards and the additional capital buffers that will be imposed on them.
Analysts largely expect that the big banks will comfortably pass the Fed's stress tests.
That would go a long way in boosting confidence in bank stocks as the stress test has been deemed fairly onerous.
While Bank of America has carefully avoided making any promises on dividends, after last year's disaster, the other big three have committed to returning more capital to shareholders.
Citigroup has said it expects to begin returning more capital in 2012, with dividends and buybacks ramping up significantly in 2013 as more excess capital is generated.
The bank now pays a pitiful quarterly dividend of one cent a share.
JPMorgan has said it will continue to buy back more stock and increase dividend modestly while simultaneously building its capital to a target Basel 3 Tier 1 Capital of 9% by the end of 2012.
Wells Fargo has also promised more dividend, though it will also likely use its strong capital position to acquire assets as European banks de-lever.
Deutsche Bank expects bank payouts (both dividends and buybacks) to rise from 27 percent to 43 percent on an average, taking the total yield on bank stocks from 2 percent to 4.3 percent.
Still, it can be argued that buybacks did not help bank stocks much in 2011.
JPMorgan spent more than $8 billion of its capital in buybacks in 2011 but still could not stop its stock from sliding 22 percent last year, even though it boasted a "fortress" balance sheet.
While valuations are attractive and fundamentals are improving — loan growth was strong in the fourth quarter going by recent data — shares of the big banks have been weighed down by an overwhelming focus on macro events in in Europe and continuing uncertainty about the impact of regulations such as the Volcker rule.
That has KBW analysts pushing for a case for smaller, regional banks.
"The overhang of capital controls on the largest banks, Dodd-Frank implementation in capital markets activities, and slowing European economic growth will keep many of the largest U.S. financial firms sidelined. As a result, we expect the best opportunities for financial stock investing in 2012 will be where capital can be deployed profitably, including life insurers, alternative money managers, credit card companies, and smaller-cap names in regional banks and real estate," analysts argued in a December report.
The analysts also believe smaller banks that are not subject to the Fed's annual capital review might have greater flexibility to return capital and more upside.
But other sell-side analysts by and large seem to still favor large-caps. Valuations are relatively more attractive, for one.
While the universal and investment banks have taken a hit because of dismal trading performance in the last two to three quarters, they could get a lift from a seasonal pickup in markets activity in the first quarter, according to Deutsche Bank analyst Matt O'Connor.
Barclays Capital analysts also recommend larger banks to mid-sized ones, citing their lower exposure to net interest spread compression and their ability to absorb the costs of regulation due to a larger customer base.
JPMorgan is the universal favorite with 29 out of 32 analysts rating it a buy. The stock is expected to do well in an environment that favors high-quality names and its strong capital position equips it to take advantage of opportunities that could emerge out of Europe.
Wells Fargo is seen as the relatively low-risk high-reward pick given its low exposure to volatile trading business. The bank is also best poised to take advantage of a wave in refinancing activity and a rebound in housing. Twenty-five out of 34 analysts rate the stock a buy.
The outlook for Citigroup is a bit more mixed. Seventeen out of 27 analysts have a buy or outperform rating on the stock, arguing that the bank is a different company since the crisis and that its international presence is its advantage.
Its promise of significant capital returns has also buoyed expectations. However, Citi remains vulnerable to a slowdown in emerging markets that makes it somewhat of a high-risk bet.
Large-cap regional bank stocks such as US Bancorp and PNC Financial also figure on the buy lists for 2012 as banks that could grow market share as European rivals withdraw from the market.
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