Why U.S. Bank Investors Shouldn't Worry About Today's Banking Problems in Europe

The Dow Jones Industrial Average (DJINDICES: ^DJI  ) was down 83 points in early afternoon trading on Thursday. The decline came on news that a large European bank, Banco Espirito Santo in Portugal, may be under renewed strains. That stock traded down over 14% in European trading. 

The banking fears didn't jump across the pond proportionally to U.S. banks, but instead spurred broad-based selling. All but seven of the Dow's 30 component stocks were lower, several over 1%.

U.S. banks down, but not out
Megabank and Dow component JPMorgan Chase (NYSE: JPM  ) traded down 0.9%, while fellow blue chip Wells Fargo (NYSE: WFC  ) dropped 0.8%, and Bank of America (NYSE: BAC  ) was down 1%.

Relative to their European peers, particularly Banco Espirito Santo, U.S. banks are today far healthier than they were in the years leading up to and through the financial crisis. 

In a kind of flashback to 2008, Banco Espirito Santo delayed making a payment due on a short-term debt obligation. Investors interpreted this as a possible liquidity shortfall, the exact same mechanism that sank Lehman Brothers, Bear Stearns, and the host of other failed U.S. institutions just a few years ago. 

Now look at the cash ratio of JPMorgan and the other U.S. banks mentioned above. The cash ratio is a more strict look at a company's liquidity relative to debt than both the more standard current and quick ratios. To calculate the cash ratio, divide the company's total cash and equivalents into its current liabilities. 

BAC Cash Ratio (Quarterly) Chart

BAC Cash Ratio (Quarterly) data by YCharts.

At first blush you may look at Wells Fargo's seemingly unchanged ratio over the past 10 years and assume the bank may be short on liquidity. But before you jump to conclusions, take a closer look.

In the years preceding the financial crisis, Wells increased its cash ratio while the other banks remained steady. As history tells us, Wells then sailed through the crisis with relative ease. That's a very impressive bit of management from what many consider to be the best-run bank in the world. 

Wells Fargo CEO John Stumpf. Source: Company Website

Bank of America struggled mightily, and that continues to today. Given the bank's myriad of problems, it's no wonder that its cash ratio has spiked so much higher. For BofA, its better safe than sorry until the controversy and asset problems subside.

JPMorgan, known of course for its fortress balance sheet, falls somewhere in the middle. Its rising cash ratio is far more stable than BofA's, rising steadily to its current 1.5 times level. This rise indicates to me a deliberate move by management to further strengthen the bank's defenses from future economic shocks. 

It pays to not run with the crowd
The point here is that U.S. banks are in a much stronger position today than they were five or 10 years ago. Capital ratios are higher across the board and liquidity is a prized position. But perceptions linger, creating some very appealing values for savvy investors.

In a crisis, having liquidity is far more important than having capital. Today in Europe, Banco Espirito Santo made moves that indicate a lack of that critical liquidity. The market reacted in fear that other banks may face the same problem. 

Bank investors in the U.S. need not worry. At present, major U.S. banks have the cash and the capital to weather a short-term economic storm. It is a lesson learned the hard way, but one that will serve these institutions well for the long term.

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