The failure of Silicon Valley Bank and Signature Bank, in mid-March 2023, sent the financial world into a steep downturn. The majority of banking stocks and bank-based exchange-traded funds (ETFs) experienced huge declines in stock prices as investors feared a 2008 banking crisis-like situation. Still, many investors are interested in bank stocks during downturns. How can they research those stocks?
The banking sector is considered the lifeline of an economy, as its business is directly tied to people’s income and expenditure levels. Any economic slowdown is sure to hit the banking sector the hardest as consumers prefer to hoard cash instead of savings or deposits in banks. Especially during an inflationary environment, consumers reduce spending as the high prices dig a hole in their pockets. The question here arises if it is advisable to buy bank stocks under such tough macroeconomic backdrops.
Remarkably, both Silicon Valley and Signature Bank had distinct lending practices such as disbursing loans to tech start-ups and cryptocurrency companies, which made their businesses riskier. It is very important to study any asset/security carefully before making an investment decision. The same rule applies to investing in bank stocks. Agreed, the common purpose of a bank is to accept deposits and lend money. But there are a few exceptions, which undertake additional services that may be risky at times.
Having said that, should we bargain hunt for quality bank stocks during a downturn? The 2008 global financial crisis did urge banks to de-risk their balance sheets, with greater regulatory requirements pushing for more liquidity, and capital buffer to repay customers during a default. However, as the environment cooled off during the decade, newer avenues such as cryptocurrencies and the like, have propelled banks to start taking risks again.
Let us see a step-by-step approach to studying banks in an economic downturn.
# Study the Macroeconomic Scenario
A bank’s performance is directly tied to the macroeconomic well-being of an economy. To analyze a bank stock, first, you must study the prevalent macroeconomic scenario. A macro environment could be marred by several headwinds including record-high inflation, ever-increasing interest rates, weakening corporate earnings, and mass layoffs.
Before you decide to invest in banks, you must consider if such a volatile and high-risk environment is aligned with your investment goals. If yes, you must understand that a high-interest rate scenario is conducive to growing a bank’s net interest income (NII). However, inflation and layoffs may weaken its customers’ borrowing and depositing capacity.
When the Federal Reserve increases interest rates, banks will keep earning higher interest incomes for a prolonged period. At the same time, the higher interest rates can also push customers to delay their borrowing needs to later dates as well as accelerate loan defaults.
# Study Each Individual Bank’s Financials
Once you have fully understood the current state of the economy and decided to dive into bank stocks, you must carefully single out a few stocks you like and study them thoroughly. Whether you want to invest in regional bank stocks, commercial bank stocks, or universal bank stocks, each will require a deep study of the income statement and balance sheet to understand the bank’s health.
- Net Interest Margins (NIMs) – A rising interest rate environment will increase a bank’s NIMs. Net interest margin is defined as the percentage of interest a bank earns on loans after paying the interest on deposits and other sources of capital. In the increasing rate scenario, a bank must try to grow low-interest yield deposits, leverage the rate increases and increase its NIMs.
- Provision for Loan Losses – Another important line item in the income statement is the provision for loan losses. Banks mandatorily reserve a part of their income as a provision in case of loan defaults. These provisions are made for loans that are either delinquent (late payments) or may not be collected at all and are higher especially during economic slowdowns. A provision for loss is subtracted from the NII, thus reducing your net income. Plus, the amount is added to loan loss reserves in the balance sheet to show the net effect of active loans held. Hence, you must keep a watch on a bank’s growing provisions to see if their loan books are becoming worse over time, which may be a sign of weakness.
- Non-Performing Assets (NPAs) – A high-interest rate scenario usually leads to higher loan defaults. Customers are unable to pay the high interest on loans nor repay the liabilities owing to inflationary pressures. Thus, it is important to study the bank’s loan portfolio. A higher proportion of non-asset backed loans such as credit card and student loans, as well as poor quality loans, may lead to higher NPAs. Thus, if a bank’s NPA is growing quarter over quarter, the bank is unable to manage its assets efficiently.
- Balance Sheet Mismanagement – Balance sheet mismanagement is often the outcome of poor lending practices and lax internal controls. Giving away too much of the deposits toward risky loans may lead to trouble. That was the case for Silicon Valley Bank, which gave most of its loans to tech start-ups, and ended up becoming insolvent. As an investor, you may want to steer clear of such banks and focus on those with healthier balance sheet management practices.
- Higher Capital Adequacy Ratios – Following the 2008 global financial meltdown, the Basel III requirements for a bank’s capital adequacy ratios have become more stringent. Banks are now required to maintain more liquidity, have a limited number of risky loans, and maintain buffers to repay customers in the event of a default. However, some banks may still undertake risky businesses and it is important to isolate such banks from the good ones. You should keep a watch on the quarterly capital adequacy and liquidity ratios to ensure the bank is maintaining enough liquidity in times of emergencies. If not, you may want to switch out of the stock.
Importantly, under normal circumstances, a bank may have maintained a good liquidity ratio, but when times turn bad, the situation may become worse and lead to a liquidity crisis. At such events, a bank may be prone to deposit flights and will not be able to return enough cash to customers, as was the case with Silicon Valley Bank.
What’s worse, banks may be forced to sell securities at a loss when depositors withdraw. Also, smaller regional banks are more prone to bank runs due to lower diversification. Please bear in mind, even in the worst of cases, a government intervention or bailout to save failing banks will only protect the depositor’s money and not the shareholders’ funds.
# Comparative Ratio Analysis with Peers
Once you have shortlisted a few banks that hold your interest, you must carry out a comparative peer analysis. For banks, several ratios hold importance, such as the price/earnings per share (P/E), price/book value (P/B), and loan/deposit ratio (LDR) for the quality of the bank, and return on equity (ROE) ratio from the investor’s perspective. These ratios need to be studied with both individual stock’s historical ratios and industry or competitor ratios to better gauge how a bank is faring.
- P/E Ratio – This ratio compares a bank’s stock price to its earnings per share to see if a stock is undervalued or overvalued relative to both its historical ratios and peers.
- P/B Ratio – This ratio compares the bank’s stock price to its book value per share, which is assets minus liabilities.
- LDR – This is a very important ratio for banks, as it compares how many loans a bank has issued out of the deposits. A high LDR means a bank is taking higher risks and may not have enough liquidity to fund any unforeseen circumstances.
- ROE Ratio – This is a profitability ratio that compares the bank’s net income to its shareholder’s equity. The ROE for banks has been falling since the 2008 collapse as higher capital buffers and stringent lending practices have kept the bank’s returns under check. Currently, rising interest rates may have pushed the ROE higher, but again as the economies await a lingering recession, this ratio might not remain high going ahead.
Here’s How TipRanks Can Help You Analyze Bank Stocks
TipRanks has all the necessary tools at your disposal to study bank stocks. We offer financial statements, stock charts, comparative ratios, technical analysis, Wall Street analysts’ consensus views and price targets, insider trading information, hedge fund buying pattern, retail investor buying patterns, and blogger opinions. With the help of all these tools, you can undertake thorough research of bank stocks and decide which one best suit your risk-reward appetite.
Moreover, TipRanks also has a Risk Analysis Page for every stock, which can help you carefully study the risks of individual banks. Every quarter, a bank releases risk factors in its filings which are updated on the TipRanks risk analysis page. The risk factors are broken down into six broad categories, namely, Finance & Corporate, Macro & Political, Legal & Regulatory, Tech & Innovation, Production, and Ability to Sell.
Shown above is a chart of risk factors of universal banking giant, JPMorgan Chase & Co. (NYSE:JPM). You can see whether any bank has added or reduced any risk factor in a particular quarter. You can even see which risk factor has the major contribution toward the overall risks and study it further by reading. A bank will typically have the highest contribution from the first three factors (Finance & Corporate; Macro & Political; Legal & Regulatory), owing to the nature of its business.
Interestingly, if an investor had carefully read the risk disclosures of the recently failed bank Silicon Valley, he/she would have realized that risk factors hinted at SIVB’s downfall. SIVB clearly stated that its credit profile is different from that of most other banking companies. Most of its loans were made to early-stage and mid-stage privately held companies in the tech, life science, and healthcare spaces.
Usually, reading a company’s risk factors can be burdensome. But thanks to TipRanks’ comprehensive and dynamic Risk Factors tool, investors can now assess the risks associated with a particular stock and keep up with the changing risk scenario.
Ending Thoughts
Buying bank stocks during an economic downturn may prove beneficial in the long run. Just ensure that you do thorough research on all bank stocks that you wish to invest in.
Even during this market turmoil, you can study and choose which stocks are better placed with healthy business practices, and buy the dip. It is an excellent opportunity to go bargain-hunting for bank stocks and make the greatest returns when their prices resume their upward trajectory after the worst is behind us. So, stay focused and use TipRanks’ unique platform to conduct research on bank stocks and pick the best one.
