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 +0.63%) and Ally Financial (ALLY +0.10%) 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.
