Don't Panic: 4 Signs the Banking Industry Is Improving

Richard Davis Source: U.S. Bank

Banking CEOs have been vocal about the significant headwinds facing the current revenue environment. We have seen, however, year-over-year improvements in net income through cost cutting, tighter lending practices, and the exploration of new revenue streams.

In US Bancorp's (USB 0.11%) fourth quarter conference call, CEO Richard Davis explained that these types of practices won't last forever. And investors should begin to look in four counter-intuitive places for signs that the economy is improving.

1. Sentiment improves
"But sentiment is always the leading indicator, right?"

While investors should normally take anecdotal evidence with a grain of salt, recessions often strike like hurricanes and we never see them coming. They wreak panic and chaos -- and then things calm. Is it just the eye of the storm? Or are we free to step outside?

Sometimes all it takes is one credible source to step outside and say, "Hey, I think we're OK."

Whether, in the case of the economy, it becomes a self-fulfilling prophecy or we are actually coming out of the woods, hearing a number of CEOs, including Richard Davis, say sentiment is stronger than it has been, and people are more "willing to talk about future investments" is a good sign nonetheless.

2. Deposit growth slows
"The first trigger in that transition of people spending is the deposits actually going down."

Source: Company filings. 

From the chart above, we can see total deposit growth has been strong for all three banks since 2009.

And while Davis explained deposit growth is great because it means new customers, it's better for banks to see deposits begin to slow -- which, hopefully, means customers are starting to extend lines of credit.

According to Davis, though, "We are not seeing as much of that yet as we like to at the early stages."

3. Net charge-offs increase
Cutting costs and tightening loan practices were completely necessary following the financial collapse -- in fact, according to the Office of the Comptroller of the Currency, or OCC, 83% of banks surveyed in 2009 tightened retail lending practices.

Source: Company filings.

With that in mind, Davis told investors not to be disappointed when charge-offs increase and provision for loan losses build up rather than being released. Davis went on to explain, "That's actually a pretty good sign that we are all getting back to doing what we are supposed to do, which is make loans to qualified people and every once in a while one doesn't get paid back."

To that point, the OCC reported 22% of surveyed banks in 2013 eased underwriting standards for retail underwriting. This is a trend investors should hope to responsibly continue.

4. Banks offering better rates to customers 
Davis suggested this recovery is, "[D]ifferent than almost any other recovery coming from a recession, [in] that it will not be the consumer that blinks first."

Normally, the banks with the best margins are the best investment -- and to some extent, that is still the case.

Davis explained, however, consumers aren't going to come back own their own, so business will need to garner interest through innovation and better rates. This may shrink margins. 

What lies ahead? 
Over the next several quarters, it's very possible banks total deposit growth will slow, net charge-offs will increase, provisions for loan losses may build up, and bank's margins may shrink to take advantage of low rates.

And while many investors may panic, smart investors will know we are returning to an economy where banks can begin taking some risk again. And that is a great sign that the economy is recovering.