Like the U.S. itself, the banking sector south of the border is a wounded giant, battered and bruised from a historic financial crisis and deep recession. With approximately 8,000 deposit-taking institutions (for simplicity, referred to here as just “banks”), and $7.5-trillion (U.S.) in loans, the system’s return to health is crucial to a durable recovery in the U.S. economy.

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Although the financial crisis ended last year, the U.S. banking sector continues to feel the effects of a severe downturn that saw credit losses reach levels not experienced since the Great Depression. And, at over three years and counting, the downturn feels as though it has been going on forever.

The stock market can be used to measure the damage. Despite a monumental rally that began in early 2009, the market cap of the 500 or so publicly traded banks (that survived) is still about 45 per cent lower than it was at the beginning of 2007.

Many sell-side analysts believe that the recent improvement in profitability represents the emergence of a durable recovery, concluding that substantial upside to share prices lies ahead. On the other hand, there is no shortage of highly vocal critics that question the sector’s health or attribute an illusory quality to it.

How can investors reconcile these two views and form their own conclusions? Focus on the four elements needed for a banking sector to emerge from a crisis of this magnitude.

First, the system must be cleansed of “bad” banks. It is here that highly active regulators with a keen sense of history have taken decisive action.

Most of the progress was made in 2008 when several giant firms either failed (Washington Mutual) or, under threat of seizure, were forced to sell to healthy banks (Countrywide, Wachovia and National City).

In addition, the regulators have seized another 270 banks of varying sizes since the beginning of 2007. In effect, this process “scrubbed” about $1.2-trillion of loans and then returned them to the banking system. It is difficult to have an informed view of the health of the sector without understanding the enormously beneficial impact of this process.

Second, the sector must recapitalize. Mandated capital raises and dividend reductions, resulting primarily from last year’s stress test, amounted to growth in tangible capital sufficient to absorb an additional $250-billion of losses.

These changes also brought combined leverage to a relatively modest (by banking standards) 12.6 to 1, belying criticism that the system has excessive leverage. And with dividends for the largest banks still effectively zero, this cushion continues to grow.

Third, the system must work through its legacy loan problems.

Since the downturn began, the banks have taken writedowns of about $400-billion against bad loans (with more than half of that balance taken in the last four quarters). The banks have also more than tripled reserves by setting aside another $200-billion to protect against further deterioration. These efforts have done much to cleanse the system.

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Fourth and finally, the sector must restore profitability, which – perhaps surprisingly to some – remained positive in each of the past three years, albeit barely.

In 2009, the U.S. banks’ net income was just $10-billion, less than that of the big five Canadian banks. However, profitability is returning to the system.

In the first quarter of this year, net earnings were $18-billion, almost double the entire preceding year. Second-quarter profits should be higher still.

At this pace, over half of the sector’s earnings power could be restored this year. Ultimately, as credit losses decline to more “normal” levels, the sector should add over $100-billion to earnings, making the recovery of the U.S. banking system a highly consequential theme in the equity markets.

All this is, of course, not to say that everything in U.S. banking is rosy. It isn’t.

The sector continues to face challenges, primarily relating to the fragility of the U.S. economic recovery and the prospect of a double-dip recession, or more ominously, the onset of deflation. Moreover, credit losses, while improving, are still mountainous.

However, investors will note that although it was painful, significant progress has been made in restoring the system back to full health. And this is good news, since a recovery in the U.S. economy depends on it.

Note: This commentary was published in the Globe and Mail on August 10, 2010.

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