Bank stocks can be excellent long-term investment opportunities, but they aren't right for all investors.
Bank stocks are generally near the middle of the risk spectrum. They can be recession-prone and their profit margins are sensitive to interest rate fluctuations, just to name two major risk factors. However, many financial institutions are extremely stable businesses with large profit margins and plenty of reserves to get through tough times.
Having said that, like most other sectors and industries, the risk associated with bank stocks can vary tremendously between companies. With that in mind, here's an overview of what investors should know about assessing the risks of potential bank stock investments.
Risks of bank stocks
The three most prevalent risks banks face are cyclicality, loan losses, and interest rate risk. Let's take these one at a time.
1. Cyclicality
Banks are cyclical businesses, meaning they are sensitive to recessions and adverse economic environments.
Think of it this way: Banks rely on consumers being willing to spend and borrow money to profit. In recessions, fewer people tend to buy cars and houses or use their credit cards. Plus, as we'll discuss in the next section, more consumers tend to run into trouble paying their debts during recessions, which can result in loan losses for banks.
It's also worth mentioning that banks are much better prepared for a terrible recession than they once were. As one example, JPMorgan Chase (JPM -1.74%) noted around the time of the COVID-19 pandemic's onset that it had run its own "stress test" using more drastic parameters than the Federal Reserve's test -- assuming a 35% contraction in GDP and 14% unemployment -- and the results showed the bank would still remain adequately capitalized with strong liquidity.
2. Loan loss (default) risk
If consumers and businesses are unable to repay their debts, it can result in losses for the financial institutions that lend money.
Banks are always prepared to absorb some loan losses. It's a normal part of the business, even when things are going well. But when recessions hit, loan losses can spike as unemployment rates moves higher and consumer spending declines. These things can lead to consumers and businesses having trouble paying back their debts. Banks typically set aside a certain amount of money to cover loan losses, but if these losses exceed the bank's reserves unexpectedly, it can be a big negative catalyst.
3. Interest rate risk
The banking business can be complex, and many institutions have dozens of revenue streams that contribute to their overall success or failure. However, at their core, most banks primarily make money in a very simple way -- by taking in deposits, lending out money, and profiting from the difference in interest rates.
With that in mind, it shouldn't come as a big surprise that when interest rates fluctuate, it tends to hurt bank profits.
Both rising and falling rates can hurt bank profits, depending on the circumstances. Falling rates can be negative since they result in lower interest rates from new loans, and many customers with outstanding loans will refinance. On the other hand, rising interest rates can be a negative catalyst because they result in higher deposit costs and lower loan demand.
The so-called yield curve can also play a role since the interest rates banks charge on loans are often correlated with long-term, risk-free interest rates, while deposit yields are more dependent on the short-term end of the yield spectrum.
4. Disruption
Another risk factor that is becoming more important to take into consideration is disruption, especially when you're looking at traditional branch-based bank stocks. Many people reading this likely have their savings accounts at newer, online-based banks, simply because they can get a higher interest rate.
The financial technology, or fintech, industry has exploded in recent years, creating tons of competitive pressure on traditional banks. Online banks such as SoFi (SOFI +0.24%) and Ally Financial (ALLY +1.33%) have a better cost structure than branch-based banks, so they can offer customers higher rates on deposits and lower rates and fees on loans, with the obvious caveat that customers are giving up branch banking convenience.
5. Panic
Every so often, there's an event that can trigger a panic related to the overall U.S. financial system or some part of it. Bank panics were at least somewhat responsible for the Crash of 1929 that triggered the Great Depression as well as the near-collapse of the banking industry in 2007-09, and for many situations in between.
The 2023 situation involving the collapse of SVB Financial's Silicon Valley Bank is a good example of this. Of course, there were company-specific risk management issues that ultimately led to the bank's decline. But panic certainly played a big role, as customers withdrew more than $40 billion from the bank the day before it was taken over by regulators.
It didn't stop there. Fears of mass withdrawals sent shares of other regional banking institutions plunging as well, even though there was little indication of major trouble in most cases.
Strengths of bank stocks
With these risk factors in mind, a few things can help mitigate the risks of bank stock investing. Here are a couple of the most important:
1. Regulation
Few industries are more heavily regulated than banking, and that became even more true after the 2007-09 financial crisis threatened to collapse the U.S. banking industry. Now banks are required to maintain certain minimum capital levels and are subject to increased government oversight. Larger institutions are required to submit to "stress tests" to determine their ability to survive in adverse environments, helping to lower the risk associated with bank stock investing.
However, it is also worth noting that regulation can also be a risk factor (especially for regional and local banks). After all, if a bank becomes insolvent or looks like it's heading in that direction, regulators can step in and take over.
2. Investment banking
Banks can engage in two main types of business. Most people associate commercial banking with banks. It involves lending money and taking deposits, and it can also include retirement planning and insurance products.
On the other hand, investment banking involves debt and equity underwriting, wealth management for high-net-worth clients, proprietary stock and bond trading, and advising institutional clients on initial public offerings (IPOs) and mergers and acquisitions.
The key thing to know from a risk perspective is that while commercial banking tends to do poorly during recessions and turbulent markets, investment banking tends to hold up nicely. In fact, leading investment bank Goldman Sachs' (GS -0.57%) posted some of its best results ever during the 2007-09 financial crisis and the 2020 COVID-19 pandemic volatility. So, while this obviously doesn't apply to banks that focus exclusively on lending, banks that have both types of operations can be somewhat lower risk in tough economies.
3. Bank stocks in tough times
When you're evaluating the risks of investing in bank stocks, as well as the strengths that are important to know, it can help to look at how they fared in tough market environments.
For example, the financial sector was one of the worst-performing areas of the market when the COVID-19 pandemic began. It fell 2% in 2020 for the full year compared to a 16% gain in the S&P 500. And all of the "Big Four" banks did even worse. JPMorgan Chase fell by 6% in 2020, and Bank of America (BAC -1.00%) was down 12%. Wells Fargo (WFC -1.52%) shed 42% of its share price, and that was after underperforming the financial sector for several years following the infamous fake accounts scandal. Citigroup (C -1.06%) was also hit especially hard in 2020 and was down by 20% for the year.
This is an excellent real-world example of three of the main banking risk factors in action: cyclicality, default risk, and interest rate risk.
Not only did a recession such as the one caused by the pandemic reduce consumer demand for loans, but since many people had lost income, there was a significant risk that borrowers could also start to have trouble paying their debts. However, thanks to strong capital cushions, all of the major U.S. banks made it through the pandemic more or less unscathed.
Related investing topics
Are bank stocks a good buy right now?
To be clear, I have absolutely no idea what bank stocks will do over the next few days, weeks, or months. I'd be willing to guess they'll be volatile as inflation, interest rate uncertainty, and recession fears continue to play out, but that's it. As we've discussed here, several factors can affect bank profitability, and bank stock prices generally don't move in a predictable manner over short periods.
Having said that, if you focus on quality banks that have a strong history of managing risks and generating profits, banks can be an excellent way to invest for the long term.
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