Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Bank profits looking gloomy, and here's why

Expect underwhelming big bank earnings: Analyst

As second-quarter earnings season cranks up, expectations are high that this may be the point at which companies stop simply beating lower expectations and show aggressive growth.

Not for the banking sector, though, which instead finds itself at something of a crossroads as Wells Fargo kicks off the profit reports Friday morning.

Financials broadly and banks in particular find themselves struggling against the twin headwinds of increased regulation and uncertainty regarding monetary policy. Reforms out of Washington are just now starting to kick in, and the Federal Reserve is expected to stop its money-pumping operation in October and begin raising interest rates the following year.

For some of Wall Street's biggest names, then, quarterly results are likely to be weak, while the future is pockmarked with uncertainty.

Scott Eells | Bloomberg | Getty Images

"There are some reasons for guarded optimism regarding the economy as the second half of 2014 begins, but we expect persistent banking challenges in areas such as mortgage finance, capital markets and net interest margins for the next several years," Christopher Whalen, senior managing director of Kroll Bond Rating Agency, said in a report for clients.

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Indeed, in an otherwise optimistic earnings environment for companies in the S&P 500—projections of 6.5 percent growth in Q2 followed by 8.8 percent in Q3 and 11.4 percent in Q4, according to S&P Capital IQ—banks are the black sheep. Financials broadly are projected to drop 1.2 percent, while banks as a subsector could post a decline of up to 10 percent, according to some estimates.

Bank executives have been preparing investors, with warnings from JPMorgan Chase and Citigroup regarding substantial trading losses that will impact earnings. Whalen also cites lower mortgage lending, declines in interest earnings and rate uncertainty from the Fed as further challenges.

"A lack of visibility as to the future direction of interest rates will be a recurring theme for banks and markets during the rest of 2014," he said. "Strong institutional demand for assets and, conversely, a dearth of consumer demand for credit will complicate the stated intention of the Federal Open Market Committee to normalize interest rate policy."

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For investors, the landscape gets even more challenging after a bad first half for banks. The KBW Bank Index has underperformed the broader market significantly, gaining just 2.3 percent compared to 6.3 percent for the . The KBW index is off 2.2 percent this week.

Wells Fargo has been by far the best performer of the group, gaining 14 percent, while PNC Bank is up 12.3 percent. Citi is off 10 percent to lead the downside performers.

Most analysts, then, are advising investors to stick with best-of-show names as the industry seeks to navigate through its challenges.

"The higher-quality names continue to perform well, and we remain constructive on those companies that have above-average growth prospects and high-quality, stable earnings streams," FBR Capital Markets said in a note.

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Heading into earnings, FBR recommends Wells Fargo and PNC along with U.S. Bancorp, First Republic Bank, PacWest Bancorp and Signature Bank.

Bank performance is expected to improve through the rest of the year, but that will depend on the direction of Fed policy and whether U.S. economic growth is as strong as expected. S&P Capital IQ expects financial earnings to grow 3.5 percent in the third quarter and 6.9 percent in the fourth quarter—though both projections are less than half what they were at the beginning of the year.

—By CNBC's Jeff Cox