Bank stocks outperformed the S&P 500 last week for the first time in five years, but just how real is their recovery?

On its face, it seems that increased investor confidence in the expansion of the U.S. economy is helping bank stocks outperform, according to Gerard Cassidy, a bank analyst at RBC Capital Markets, who noted in a report Monday morning that the U.S. economy is expected to grow 2.6 to 3 percent in 2010.

The stellar performance of bank stocks, in his view, is also helped by the announcement by Christopher Dodd, the Connecticut Democrat who chairs the Senate Banking Committee and has sponsored a bill that would strip the Federal Reserve of its authority to oversee banks and limit banks' influence over the composition of the boards of the Fed's member banks, that he would not seek reelection.

In addition, says Cassidy, the stocks have been helped by signs that banks would continue to be able to count net operating losses as regulatory capital.  And there's been no recent indication that banks' earnings will not continue to improve.

But it's difficult to believe that bank stock valuations aren't inflated when there's still strong support from the government through direct federal subsidies as well as a Federal funds rate of almost zero, not to mention accounting leeway that lets banks ignore hits to earnings from losses on assets not held to maturity.

In addition, some banks, mostly smaller ones, continue to face difficulties, especially from losses on commercial real estate loans. Indeed, the number of bank failures continues to mount, which also leads Cassidy to expect mergers and acquisitions to heat up in 2011.

"The driving force behind the traditional M&A activity will be the need for loan growth and earnings accretion from the potential cost savings from the transactions," he wrote. He sees KeyCorp, SunTrust Banks and Webster Financial as acquisition targets.

But consolidation will lead to bigger banks, and with bigger banks comes more systemic risk, suggesting the next credit crisis could be even more severe than the last one.