Starting as a credit issue in the subprime segment of the U.S. mortgage market, the worst financial crisis since the Great Depression spread to almost the entire financial services industry and all corners of the globe. However, we believe that the worst of the global financial crisis is now probably behind us. Although non-U.S. banks are still dealing with liquidity and confidence challenges, governments have taken several steps to alleviate the sector, as banks are the lifeblood of the economy.

Though the industry is in the process of adopting tougher measures to help prevent a recurrence of the global financial crisis and restore public confidence, we believe it would be a bit early to get involved with non-U.S. bank stocks, as the near term fundamental outlook remains weak — asset quality is expected to continue to deteriorate as individuals and companies default on loans, and revenue growth should remain stretched as loan growth falters and investment banking faces a dearth of new business despite the economic recovery.

Increasing unemployment and sluggish business conditions worldwide are expected to dampen demand for credit, though banks are now capable of lending more. Moreover, these factors will also hurt asset quality and increase losses on the existing “good” loan portfolios, even apart from the toxic assets. Combined with top-line pressure due to weakening economic conditions, non-U.S. banks face a discouraging outlook.

Although the upturn in the banking sector in 2010 will vary from country to country, depending on industry circumstances, we believe that banks in stable emerging economies, such as Chile, Brazil or India, may be more attractive investments — similar to what we expect for certain regional banks in the U.S.

To be sure, banks in emerging economies will face asset quality issues. However, they are not confronted with other significant problems that many of the larger banks face in continental Europe and the United Kingdom, such as toxic securities, dilution from capital raising and dividend cuts/omissions. Moreover, these emerging-market banks generally tend to be well capitalized, aren’t as heavily exposed to property markets, and have significant and generally growing sources of non-interest income.

The Institute of International Finance, which represents major financial institutions in 70 countries, said in a report that the firms are learning from the crisis. But there are several issues worth considering when investing in these banks:

First, investment in non-U.S. ADR bank stocks entails foreign currency risk. Currently, the U.S. dollar is remarkably volatile against many foreign currencies, which tends to depress the share performance. Importantly, we expect volatility in the stock prices to continue, reflecting economic uncertainty in the coming months and headline risk.

In all, a key determinant for quick recovery will be the quality of risk analysis and how well risk awareness is built into decision-making and incentive policies. So we believe that accumulating larger capital buffers over the cycle and reducing pointless complexity in business will be crucial for the better performance of non-U.S. banks.

OPPORTUNITIES

Specific banks that we like with a Zacks Rank of 1 (Strong Buy) include Banco Santander Santiago (SAN) in Chile, Credit Suisse Group (CS) in Switzerland, Deutsche Bank AG (DB) in Germany, HSBC Holdings Plc (HBC) and Banco de Chile (BCH).

We also like HDFC Bank Limited (HDB) and ICICI Bank Limited (IBN) in India. Both of these banks have recently been emphasizing strong cost controls and improved operating efficiency, rather than growth, as key strategies. As a result, these banks have been able to offset some of the earnings pressure from higher loss provisions due to weakening asset quality. We anticipate continued synergies from these banks’ cost-containment measures and operating efficiency.

There are currently a number of stocks in the Zacks covered non-U.S. bank universe with a Zacks Rank of 2 (Buy) Incorporatedluding Banco Bilbao Vizcaya Argentaria, S.A. (BBVA), Banco Bradesco S.A. (BBD), Banco Latinoamericano de Comercio Exterior, S.A. (BLX), Banco Macro S.A. (BMA) and Banco Santander, S.A. (STD).

WEAKNESSES

We would suggest avoiding the larger banks in Great Britain and Ireland, particularly those that that have participated in government recapitalization programs, such as The Royal Bank of Scotland Bank plc (RBS) and Lloyds Banking Group plc (LYG) in Britain, Allied Irish Banks (AIB) and The Governor and Company of the Bank of Ireland (IRE). In return for government capital and asset quality protection, these banks are facing government intervention Incorporatedluding limits on dividend payouts and the nomination of board members. These issues could continue to hurt share price performance in the near future.

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