Banks should include the risks of buying their stocks within share prices. Most of the time, buyers don't know what the banks are doing behind the scenes. This means they assume all of the risks when investing in bank stocks.
Interest rates, loan approvals, and default rates are critical factors of bank stock investing. Learn how banks loan your money to others to create profit for themselves and place extra risk on your money at the same time.
How Banks Operate
A bank takes in money from people who create checking and savings accounts. It also sells them certificates of deposit and other products. The bank then lends the money from these funds to other people who apply for loans. These loans could be mortgages, business loans, construction loans, or many other projects.
One of the ways a bank makes money is on the difference between how much it pays out in account interest and the interest income on the loans. The interest paid on loans from borrowers must be greater than the interest payments it makes to depositors.
How an Accounting Reserve Works
You receive cash when you borrow money from a bank. Your loan becomes an asset when it is entered into the books. The bank then creates a company-wide reserve on all of its loans for expected losses. It might say, “We think that 1% of all these loans will default,” so it opens an accounting reserve that lowers the value of the loan on its books.
A reserve is simply money set aside to cover future losses on these loans.
The bank has already created a buffer to absorb the shock if you default on your loan. It can do this without ruining its reported earnings.
A bank might also view loans on an individual basis, making a reserve when it appears that the borrower might have problems paying it back.
A Hybrid Model: Other Fees
Banks relied upon interest income in the early days of banking. That created profit for the owners, and it funded future growth, but modern banks have embraced a hybrid model.
When banks switched to that model, they found that they made more than 50% of their profits from fees such as:
- Merchant payments
- Credit card processing
- Bank trust departments
- Mutual funds
- Insurance brokerage
- Overdraft charges
You should weigh these factors when deciding how to invest, because they all increase the risk to you.
Big-name investors, including Warren Buffett, sometimes invest in shares of a few select banks, even with the risks.
Bank Stock Crisis or Distraction?
Large reserves are significant for a healthy bank to maintain profits. It would be bad for shareholders if 4% of their loans were to default instead of the 1% they had thought would. That could wipe out a large portion of the book value and create huge losses for the bank and the investors.
Adverse economic conditions can cause severe concerns for bank investors. A lot of income from fees can be generated from mortgage originations, and fewer home sales mean less fee income.
It’s All About Loan Quality
Whether bank stocks are good investments comes down to the quality of the underlying loans in a bank’s portfolio.
As one great investment giant said, it’s tough to get a lot of eager young men and women who can create earnings with the wave of a pen to contain themselves when the economy is running strong, and every loan looks good.
Your probability of better-than-average returns on bank stocks is improved if the stock is held in a tax-advantaged account such as a Roth or traditional IRA. You can take a tax deduction for contributions made to a traditional IRA, and you can take tax-free withdrawals from a Roth IRA in many cases if you're over age 59 1/2. In either case, you'll have added benefits beyond your investment returns.
When deciding on a bank loan, think about what might happen, the return you could get, and what a reserve loss would mean for the bank. Compare the loss of reserves for similar banks. If it looks like it's out of line, you have a reason to be concerned.
Frequently Asked Questions (FAQs)
What is the average P/E ratio for banking stocks?
To get a sense of the average price-to-earnings (P/E) ratio for banking stocks, you can look at XLF, an ETF that tracks the financial sector. XLF's P/E ratio is 13.75. That means bank stocks with P/E ratios lower than 13.75 could signal a relative deal, and higher ratios could signal a relatively expensive stock.
What happens to banking stocks when interest rates fall?
When interest rates fall, that means the interest rates on new loans also fall. For many banks, this means that lower interest rates directly reduce profits. Many stock sectors tend to benefit from decreasing interest rates since low rates allow them to cheaply borrow the cash needed to expand the business. The financial sector, as the lender on the other side of those low rates, might not share in these benefits. Remember, these are just general rules of thumb that can guide expectations; banks can still be profitable during low-rate environments, and banking stocks don't always underperform in those times, either.