Bank stocks can be excellent long-term investment opportunities, but they aren't right for all investors.
Bank stocks are near the middle of the risk spectrum. They can be recession-prone and are sensitive to interest rate fluctuations, just to name two major risk factors. But, like most other types of businesses, 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.
Banks are a rather cyclical business, meaning they are sensitive to recessions. 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. And, 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 used to be. JPMorgan Chase (NYSE:JPM) 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.
Loan loss (default) risk
If consumers and businesses are unable (or unwilling) to repay their debts, it can result in losses for the banking institutions that lend money. Banks are always prepared to take some loan losses, even when things are going well. But when recessions hit, loan losses can spike as consumers and businesses have trouble paying back their debts.
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, banks primarily make money in a very simple way -- by taking in deposits, lending out money, and profiting from the difference in interest rates. So it shouldn't come as a big surprise that when interest rates fall, it tends to hurt bank profits.
To clear up one common misconception, falling interest rates hurt bank profitability but not by as much as you might think. Let's look at Bank of America (NYSE:BAC) as an example. From the end of 2018 to the end of 2021, the federal funds rate (the benchmark interest rate the Federal Reserve controls) declined by 225 basis points, or 2.25 percentage points. Bank of America's net interest yield certainly fell, but only by 85 basis points, from 2.52% to 1.67%. Falling rates are generally negative for bank profit margins, and rising rates are a positive catalyst, but it isn't exactly a one-to-one relationship.
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. The financial technology, or fintech, industry has exploded in recent years, and this has created tons of competitive pressure on traditional banks. For example, online banks 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.
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:
Few industries are more heavily regulated than banking, and that became even more true after the 2008-2009 financial crisis threatened to collapse the U.S. banking industry. Now banks are required to maintain certain minimum capital levels. Larger institutions are required to submit to "stress testing" to determine their ability to survive in adverse environments, helping to lower the risk associated with bank stock investing.
Banks can engage in two 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. 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 do better. In fact, the second quarter of 2020 -- the height of the COVID-19 pandemic shutdowns -- marked leading investment bank Goldman Sachs' (NYSE:GS) second-best quarter ever at the time in terms of revenue. 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.
Bank stocks in the COVID-19 pandemic
When you're evaluating the risks of investing in bank stocks, it can help to look at how they fared in tough market environments. We briefly touched on the 2008-2009 financial crisis, but the COVID-19 pandemic has been almost as challenging for banks -- especially in the early days -- and is a great example of some of the risk factors discussed previously.
The financial sector was one of the worst-performing sectors in 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 was down 12%. Wells Fargo (NYSE:WFC) shed 42% of its share price, and that was after underperforming the financial sector for several years following the infamous fake accounts scandal. Citigroup (NYSE:C) 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. (Thankfully, the government acted swiftly to provide financial cushions for people.)
Are bank stocks a good buy right now?
To be clear, I have absolutely no idea what the big bank stocks will do over the next few days, weeks, or months. I'd be willing to guess they'll be volatile as the economic effects of the COVID-19 pandemic and recession 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 means of investing for the long term.
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