These banks could surprise on earnings

Bank earnings are coming up and based on the performance of bank stocks in recent months, you might think that earnings would be a disappointment. But, that isn't necessarily the case for all bank stocks.

There are two big concerns for bank earnings: weak trading activity and low interest rates.

It certainly appears to be correct that trading profits may be low. Equity trading and trades in government bonds may have been OK in the quarter but activity in a wide range of other financial instruments has been weak to terrible. On the terrible side, one can point to agency, asset-backed bond, and commodity trading. On the weak side, one can look at corporates, municipals, and currencies.

This may be bad news for the big banks but it isn't for regional banks because they're not major actors in the trading business.

Regional banks make money by originating, holding, and selling loans. This has been a good business in the third quarter. Commercial lending has slowed but it is still operating at an above-average pace. Commercial real-estate lending remains hot.

There has been a shift in consumer lending with credit-card activity picking up due to more people working and housing prices increasing. Automobile lending is hot.

The residential real-estate industry is waking from a Rip Van Winkle snooze. Home mortgage activity is stronger on the purchase side. Home-equity lending is still deep in the doldrums but it seems to be showing some signs of turning around.

Interest rates are certainly low and they may not be increased until 2016 as some savvy pundits think. However, interest rates are not going to be cut. In the second quarter, with interest rates at current levels, banking industry net interest margins actually went up, according to FDIC numbers. They could be flat to up in the third quarter also.

The reason is simple: A shift in mix. Consumer loans are now growing faster than commercial loans. The rates on commercial loans are meaningfully lower than the charges on consumer loans. Thus, as consumers start to become a more dominant factor in loan portfolios net yields will rise.

There is also a second factor to consider here: the impact of regulation. Two government regulations — the liquidity coverage ratio (LCR) and total loss-absorbing capacity (TLAC) — forced banks to put money at the Federal Reserve, where the rate yield was 25 basis points. They also forced banks to borrow money in the long term debt markets at 5 percent to 6 percent. The government was forcing banks to borrow long and lend short, which kills margins.

Evidence suggests that the majority of regional banks now meet government standards. This means they can take incremental funds and place them into relatively high-yielding loans instead of Federal Reserve deposits. This will help margins.

The point here is that simply looking at the federal-funds rate is not the only way to assess bank margins. There are other factors at play and they are positive not negative. Selling regional banks stocks because the Fed has not raised rates is a very short-sighted game.

Other considerations also favor regional bank earnings in the quarter. Fees are going up. Costs are coming down. Fees are driven by charges on bank accounts and when making new loans. Costs are benefitting from fewer litigation issues and lower personnel expenses.

I love the big bank stocks. I think they are unusually cheap. However, leaving that argument aside for the moment, regional banks are very favorably priced. Their earnings outlook for the third and fourth quarters is positive. At Rafferty Capital Markets, we currently have recommendations on Capital One, First Republic, PNC Financial, SunTrust, and U.S. Bancorp.

Commentary by Richard X. Bove, an equity research analyst at Rafferty Capital Markets and the author of "Guardians of Prosperity: Why America Needs Big Banks" (2013).