Universal Banks: How Much Risk Is Involved?

In this clip, Industry Focus: Financials host Michael Douglass and Fool.com contributor Matt Frankel discuss the risks investors should be aware of when investing in universal banks. Sure, they all look like low-risk stocks during a long bull market, but what about if things go bad?

A full transcript follows the video.

This video was recorded on Jan. 29, 2018.

Michael Douglass: What risk is the bank taking on to achieve those earnings? This is one of the tougher things to quantify, particularly in a many-year bull market. Frankly, your non-performing loans are going to tend to be a roughly small percentage of things, even if you're lending out in a kind of risky fashion, because the economy is humming along, unemployment is going down, wages are going up, people in general are doing pretty well. The real key when thinking about risk is what happens when the tide goes out, and when the economy turns. Right now, you look at all three of these banks, their non-performing loan percentages are between 0.6% and 0.7% of gross loans. That's nothing. And their allowances, which is the money that they're setting aside to cover that, is, in most cases, about double what's currently non-performing. That's a very conservative, very appropriate amount of money to set aside, recognizing that not every loan gets paid back.

So I feel fine about the risk outlook for now. I think one of the key things to consider, though, is that all three of these banks suffered substantially when the financial crisis came through. And one of the big questions that any investor is going to have to ask going forward is, what did they learn, and how are they going to do things differently next time?

Matt Frankel: One thing I'd add to that is, in a couple of months, you'll start to see headlines about the banks' stress tests. This is where that information can be very useful, because it can give you an idea of what can happen if things don't go very well. I always say, every investment recommender looks like a genius when the market keeps going up and up. You can't make bad picks. And the same kind of logic applies here. Banks look great when everything's going fine, consumers have plenty of money, unemployment is at a historic low. But, it's when unemployment jumps to 6% or 7%, wage growth goes to a standstill, you have a deflationary environment, that's when you start to see where the really good banks are. And this is what I'd say -- in a few months, when you start seeing the stress tests in the news, that's something to pay attention to.

Douglass: Yes, because one of the key things to remember with banks is, they are institutions that use a fair amount of leverage. So, when thinking about that leverage, that means they don't keep enough cash to pay off everything on the spot. That's why you had runs on the banks back in the Great Depression and all that. The idea here is, you want to make sure they have appropriately priced their risk profile. Fortunately, the stress tests are the best guess that the U.S. regulatory regime has for how to basically grade whether they're doing that appropriately. That's going to be very, very important to look at.