The KBW Nasdaq Bank Index, which tracks large U.S. bank stocks, is down nearly 19% this year. Meanwhile, the S&P 500, a benchmark for the broader stock market, has only fallen by about 15%. I continue to be baffled by this wider sell-off of bank stocks when conditions for banks have improved, their core earnings are trending well, and credit seems extremely healthy. Ultimately, I do not think the broader sell-off of the banking sector is justified, and I believe there is an opportunity in the space. Here's why.

Margins are widening

Since the Great Recession, banks have been waiting for higher interest rates. At long last, here they are, in a big way. The Federal Reserve's benchmark overnight lending rate, the federal funds rate, sits between 2.25% and 2.5% and analysts and economists expect it to end the year higher. This has enabled banks to earn more on loans, securities, and cash, especially as loan growth has bounced back, and this revenue is projected to accelerate for the rest of the year. The net interest margins (NIM) of the four major U.S. banks all grew in the second quarter.

Bank NIM Q1 2022 NIM Q2 2022
JPMorgan Chase (JPM 0.50%) 1.61% 1.68%
Bank of America (BAC 0.92%) 1.69% 1.86%
Citigroup (C 0.05%) 2.05% 2.24%
Wells Fargo (WFC 0.92%) 2.16% 2.39%

Source: Bank earnings materials.

A recession could slow loan growth, and investors may also be concerned that deposit costs will eventually rise with higher rates and cut into margins. But so far, bank management teams say they haven't been surprised by deposit costs thus far. It will likely take longer before deposit costs start to rise more significantly, but banks have also greatly improved their deposit bases, hauling in stickier funds that are less sensitive to rising interest rates.

Another possible concern is that quantitative tightening, in which the Fed reduces its balance sheet and effectively pulls liquidity out of the economy, could reduce deposits in the banking system. This could likely happen as well, but most banks have very healthy loan-to-deposit ratios right now. For the past two years, they've had more deposits than they know what to do with. In JPMorgan's case, having all these deposits has become a regulatory burden.

Pressure on fee income

Another reason investors may have been selling banks this year is because of pressure on fee-income-generating businesses. Higher interest rates have put a dent in mortgage banking revenue, as refinancings have dried up.

Additionally, investment banking has taken a hit, as issuances like initial public offerings have been almost nil this year because of falling valuations and intense market volatility. JPMorgan Chase's investment banking fees fell by 54% in the second quarter on a year-over-year basis, and most other large banks have seen similar declines.

But investment banking revenue is often unreliable and unpredictable, and trading revenue has held up well with all of the market volatility. I am sure there is a good chance investment banking will bounce back next year, and many believe the overall market will be bigger than it was before the pandemic. The drop-off in the mortgage market is to be expected with rising rates and is more than offset by surging net interest income from higher interest rates.

Strong credit and capital

Banks are heavily linked to the economy, so many investors worry a potential recession could hurt the sector. While a recession would likely not be good for the industry, I feel that large banks deserve more credit after everything that has happened since the pandemic started.

At the onset of the pandemic in early 2020, when it looked like the economy could be closed for months, U.S. banks set aside tens of billions of dollars of reserves to prepare for huge potential losses. While those losses never materialized, the provisions cut deep into banks' bottom lines, and the industry still fared extremely well given the circumstances. Loan losses and delinquencies are near historic lows right now. But no matter what kind of recession may be coming -- if one is -- I don't think any bank management team expects a repeat of 2020 or anticipates the need for the same amount of loss reserves as they did then.

Banks are also extremely well capitalized right now. In the Fed's annual stress test, which put the 33 largest banks with a significant U.S. presence through a hypothetical recession that included an unemployment rate of more than 10%, the cohort performed very well. The 33 participants suffered aggregate losses of $612 billion during the nine-quarter recession on loans, trading, securities and from counterparties. As a group, they had an aggregate loss of nearly $198 billion and still maintained very strong levels of regulatory capital, more than double the required amount.

Is the banking sector a buy?

There are good bank stocks and bad bank stocks, but on the whole, it looks like the sector is being underestimated right now. Banks are set to enjoy the most rapidly rising interest-rate environment in more than a decade. Not only did they perform well in the Fed's stress test, but they also went through and performed well in a real-life stressed scenario during the pandemic -- probably a worse scenario than anyone could have imagined. There will always be uncertainties in the environment, but I think the sector is a buy right now.