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 as with 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

Young woman analyzing stock chart.

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Risks of bank stocks

The three most prevalent risks banks face are cyclicality, loan losses, and interest rate risk. So let's take these one at a time.

Cyclicality 

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) recently said that it has run its own "stress test" that uses more drastic parameters than the Federal Reserve's test -- assuming a 35% contraction in GDP and 14% unemployment -- and that the results show that 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 2019, the federal funds rate (the benchmark interest rate the Federal Reserve controls) declined by 75 basis points, or three-fourths of a percentage point. Bank of America's net interest yield certainly fell, but only by 17 basis points, from 2.52% to 2.35%. So while the 150-basis-point rate reduction implemented by the Fed in response to the coronavirus crisis is going to hurt bank profits, they aren't exactly going to zero.

Disruption

Another risk factor that is becoming more and 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 times, 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. Just to name a couple of the most important:

Regulation

Few industries are more heavily regulated than banking, and that's especially 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, and larger institutions are required to submit to "stress testing" to determine their ability to survive in adverse environments. This helps to lower the risk associated with bank stock investing.

Investment banking

Banks can engage in two types of business. Commercial banking is what most people associate with banks. It involves lending money and taking deposits, and it can also include things like 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 -- was leading investment bank Goldman Sachs' (NYSE:GS) second-best quarter ever 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 nearly as challenging for banks and is a fantastic example of some of the risk factors discussed earlier. 

One of the worst-performing sectors in the market during the COVID-19 pandemic has been the financials, down by 22% in 2020 through September compared to a 5% gain in the S&P 500. And all of the "big four" banks did even worse. JPMorgan Chase fell by 30% through the first nine months of 2020, and Bank of America was down 32%. Wells Fargo (NYSE:WFC) shed 56% of its share price, and that's after underperforming the financial sector for several years following the infamous fake accounts scandal. And Citigroup (NYSE:C) was also hit especially hard, down by 46% since the market plunge began.

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 does a recession like the one caused by the pandemic reduce consumer demand for loans, but since many people have lost income, borrowers could also start to have trouble paying their debts. A sharp increase in defaults could result in big losses for banks. We won't know the full economic effects of the pandemic for a while, but most banks (including the big four) are setting aside billions in anticipation of a wave of loan losses. And on interest rates, the record-low rate environment isn't helping matters. The benchmark 10-year Treasury yield is just above 0.7% as I write this, down from nearly 2% at the beginning of the year. Mortgage rates are at historic lows, and other lending rates have fallen as well, creating a suboptimal profit environment for businesses that primarily lend money to consumers and businesses. 

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 that they'll be volatile as the economic effects of the COVID-19 pandemic and recession play out, but that's it. As we've discussed here, several factors can affect bank profitability, and banks' 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 excellent means of investing for the long term.