On the surface, banks did not fare very well in 2020. Most bank indexes are down year to date, while the S&P 500 is up more than 14%. But considering the gravity of the situation presented by the coronavirus pandemic, banks held up pretty well in an economic scenario that was unimaginable not too long ago.
With the possibility of returning to a somewhat normal life next year if vaccine efforts prove successful, the banking sector is positioned for a rebound. And that's why your resolution should be to buy more bank stocks in 2021.
A cyclical sector
In general, most bank stocks are cyclical, meaning their performance is linked to the overall economy. When the pandemic hit earlier this year, it caused one of the most abrupt and severe recessions ever, shutting down broad swaths of the economy, causing massive dips in spending, and forcing people into their homes seemingly overnight. The scenario also quickly pushed the economy into a recession, forcing the Federal Reserve to rapidly drop its benchmark lending rate from 2% to practically zero.
This hurt banks significantly because it put lots of consumer and commercial borrowers in shaky financial position, forcing banks to set aside huge sums of money to prepare for future potential loan losses. The drop in interest rates also made a lot of the interest payments on existing loans re-price downward, resulting in less interest income for banks. These are the main reasons the banking sector struggled this year compared to other parts of the market.
While interest rates are expected to remain low for at least the next few years, being cyclical also means that banks should benefit from an economic recovery. For one, it might allow banks to avoid some of the loan losses they are projecting. Hopefully, it will also allow more people and businesses to return to normal spending levels, and feel confident enough about the economy that loan demand starts to increase.
A renewed reputation
Banks are likely going to come out of the pandemic looking a lot better than they did going in. During the Great Recession, banks were seen as one of the main culprits behind the mess, and it's been hard for people to shake that memory. The pandemic has actually helped banks revive their reputation in two ways: It helped them be part of the solution and not the problem, and it proved that the banking sector is much safer now than it was during the Great Recession.
Whether it was the failure of Lehman Brothers or numerous other financial institutions, the banking sector looked terrible coming out of the Great Recession. The general public and politicians blamed the sector for sparking the crisis, while shareholders lost faith in the sector after losing a lot of their money.
This time around, banks did not start the coronavirus pandemic, but they played an active role helping to fight its effects. Bankers worked around the clock to distribute hundreds of billions of dollars allocated by Congress in the Paycheck Protection Program intended to help struggling small businesses hit hard by the pandemic. It was a valiant effort and one that put the industry in plain view for the public to see.
The second thing the pandemic did was give the sector its first real test since the Great Recession. Following the recession, Congress passed the Dodd-Frank Act, a regulatory bill intended to make sure banks were better prepared for another financial crisis and would sustain sufficient levels of capital during such an event. While there was some significant intervention by the Federal Reserve and government, Dodd-Frank proved successful in keeping the banking system well capitalized in an extremely severe economic scenario.
The Federal Reserve's recent round of stress testing showed that many banks could sustain double or even triple the amount of loan losses they are currently projecting and still stay well capitalized, maintaining their ability to lend to individuals, families, and businesses during a severe recession. The country's largest banks that people were worried about proved their resilience, with players like JPMorgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC) setting aside tens of billions for potential loan losses and still generating solid profits. Banks also seem to have much better underwriting standards since the Great Recession, and no longer appear to be doing the type of risky lending that really got them into trouble during the recession.
A new industry emerges
With subdued loan demand and the low-rate environment, banks face no shortage of challenges heading into 2021 from a revenue and profitability standpoint. But many bank stocks are still trading lower than what they started the year at, and it's not like banks don't know how to operate in the low-rate environment, having essentially done it for a decade following the Great Recession.
The pandemic also showed banks just how important digital banking and technology is to their future. The banks that were investing in their technology will reap the rewards, and the ones that didn't will finally start to get serious or choose to get acquired. Consolidation, particularly in the regional-bank space, will create banks that can better compete with the largest banks in the country and the many fintech players that have challenged banks in recent years.
The pandemic has so far been a particularly difficult challenge for banks, but it could make them stronger in the long run.