Anytime you invest in a bank stock, the first question you need to ask is this: How will the bank hold up during the next economic downturn?
I say that because banks fail all the time. And when banks fail, their shareholders lose everything.
One way to predict whether a specific bank is prone to failure is to familiarize yourself with its operations and history. Lenders that have low expense ratios, widely diversified revenue streams, and a long record of prudent risk-management are much better positioned to survive and even thrive throughout turbulent markets.
But learning all of this takes time -- a lot of time. And most investors don't have all day to pick through thousands of pages of a bank's past regulatory filings to make a responsible determination.
A great proxy for this arduous process is the annual stress test administered by the Federal Reserve -- take the results from this year's test as an example. While there are a number of components to the test, the one that best demonstrates the strength of the underlying banks is how much money they would hypothetically earn or lose throughout the course of a severe economic cataclysm akin to the financial crisis of 2008-2009.
Not surprisingly, most banks would lose money. It's estimated, for instance, that JPMorgan Chase, the nation's largest lender, would lose an astounding $54.9 billion. In fact, all but seven of the 31 banks stress tested this year were projected to experience losses of varying degrees under the Fed's "severely adverse" economic scenario.
And then there are the banks that are projected to continue earning a healthy return throughout the hypothetical crisis. These are the banks that investors should be focused on.
They include:
- American Express
- The Bank of New York Mellon
- BB&T Corporation
- Discover Financial Services
- Northern Trust Corporation
- State Street Corporation
- US Bancorp
This is a motley assortment when you consider that it contains two traditional lenders, two credit card companies, two custodial banks, and one primarily trust-type operation.
What they all share, however, are traits that shield them from the often-debilitating credit risk that accompanies economic downturns. State Street, The Bank of New York Mellon, and Northern Trust rely on fee-based businesses with little credit exposure. American Express and Discover do so by screening their customers carefully. And US Bancorp and BB&T do it by keeping expenses low and credit standards high.
The point is that, if you're interested in buying a bank stock, these seven would be a great place to start (and even end) your search.
