By now you have probably noticed that banking stocks are down considerably when compared to the rest of the stock market.
The banking industry has seen its fair share of turmoil and speed bumps in 2023, leading many investors to wonder if they should steer clear of the sector entirely, or if they should buy banking stocks now at significantly undervalued prices.
The answer to this question is quite complex given the recent bankruptcies and liquidity troubles from regional banks. And before investors rush to purchase beaten down stocks in the hopes they will recover in the coming months and quarters, investors should be sure they understand the current economic backdrop, as well as identify the smartest investing strategies for investing in the banking sector right now.
With this in mind, we will be taking a detailed look at what is going on in the banking industry today, explain what makes banking stocks so risky right now, and identify the best ways to invest in the banking sector in 2023.
What’s Going on in the Banking Industry in 2023?
On March 10, a significant crisis unfolded in the US banking sector, marking the largest failure of an American bank since the 2008 global financial crisis.
Silicon Valley Bank (SVB), an investment banking specialist to the tech industry based in California, experienced a classic bank run as its customers hurriedly withdrew their funds, ultimately leading to the intervention of US regulators who assumed control of the situation.
This collapse was felt across the financial landscape, highlighting challenges faced by already vulnerable financial institutions grappling with the repercussions of surging interest rates and poor risk management practices.
A week later, the turmoil from SVB failing had far-reaching consequences, resulting in the closure of a second US regional bank, Signature Bank, while another, First Republic Bank, was sustained through external support.
The failure of SVB and Signature Bank marked the most significant banking collapse in the US since the case of Washington Mutual in 2008.
How Did This Happen?
The unraveling of the financial sector truly began when SVB faced substantial losses while liquidating US government bonds in a bid to generate funds for depositors. Subsequent unsuccessful attempts to sell shares to bolster its financial position triggered a panic that ultimately led to the bank’s downfall.
The repercussions of SVBs failure to meet their liquidity requirements quickly cascaded throughout the entire US economy.
Soon after SVB declared bankruptcy, the Federal Deposit Insurance Corporation (FDIC) was forced to intervene and close down Signature Bank, which faced a run on its deposits as customers reacted to the SVB crisis (Both institutions had notably high ratios of uninsured deposits, contributing to their vulnerability and lack of funds).
The crisis escalated further, when it was discovered that a third regional bank, First Republic, stood on the edge of bankruptcy. A coordinated effort involving the US Treasury Secretary and US bank JP Morgan, created a rescue plan to prevent the bank from going under. This agreement involved a large group of American lenders depositing substantial sums of
All this has led to a banking sector in 2023 which is less than ideal. High inflation and rising interest rates is exposing weakness in capital markets, leading to the failure of multiple banks throughout the US economy.
As a result, many financial companies have seen their share price take a hit, as investors look to distance themselves from an industry that has proven to be unprepared in dealing with rising inflation and tightening credit conditions.
What Makes Bank Stocks so Risky Right Now?
Before we can answer the question: are bank stocks a good buy right now? We need to first understand the current risks that regional bank stocks carry.
Below are the 3 most important risks investors should ensure they understand before choosing to invest in the banking and financial sector:
Banks inherently operate within cycles, rendering them sensitive to economic shifts. The foundation of their profitability rests upon consumers’ willingness to spend and borrow funds. During periods of economic recession, a reduced number of consumers engage in substantial transactions like purchasing cars or homes, and credit card usage diminishes. Additionally, economic downturns often lead to struggles with debt repayment, putting further stress on a banks balance sheet.
An ever-present risk for banks is the possibility of loan losses, commonly referred to as default risk. This risk materializes when consumers and businesses encounter financial stress, making them unable or unwilling to fulfill their debt obligations.
Banks incorporate a certain level of loan loss anticipation even in favorable conditions. However, during economic downturns, this risk escalates significantly as individuals and businesses grapple with repaying their debt on time.
And when consumers and businesses can’t repay their debt, means banks will have to find the capital to meet their own debt obligations somewhere else. Typically, this isn’t a problem as banks keep a healthy amount of cash on hand for this purpose. However, when defaults begin happening on a regular basis, a bank can be ill-prepared to handle such high default risk, leading to illiquidity and the inability to pay off their debt.
Interest Rate Risk
While the banking sector involves complex operations, a large part of their revenue generation rests on investing in government bonds and other fixed income assets.
And as interest rates rise (along with inflation), means a banks investment portfolio may have to take a considerable hit as interest rates eat into investment income. This in turn, creates a liquidity issue for banks which need their investment income to pay off debt obligations and provide capital to borrowers.
In conclusion, these three risks, cyclicality, default risk, and interest rate risk, are what make bank stocks so risky to invest in today. Deteriorating credit prompted banks to have to raise capital through extreme measures, which ultimately led to shareholders panicking and banks going belly up.
And while it appears the turmoil in the banking sector is over, the industry still represents considerable risk for investors to consider.
Given this, the next section will highlight some ways investors can still invest in the industry while limiting their overall risk profile.
The Best Way to Invest in the Banking Industry in 2023
One strategy that stands out amid the current uncertainty in the banking world, is investing in bank-focused exchange-traded funds (ETFs).
These diversified investment vehicles offer exposure to a range of banking stocks, allowing investors to navigate the dynamic landscape of the industry with a measure of stability and diversification.
Some of the most well diversified and popular banking ETFs for investors to consider include:
- Financial Select Sector SPDR Fund (XLF): This ETF tracks the performance of the Financial Select Sector Index, which includes various financial services companies, including banks. It provides exposure to a broad spectrum of banking giants and financial institutions within the United States.
- iShares U.S. Financials ETF (IYF): This ETF seeks to replicate the investment results of the Dow Jones U.S. Financials Index. It encompasses a comprehensive range of financial stocks, including banks, insurance companies, and other diversified financial services firms.
- SPDR S&P Regional Banking ETF (KRE): Focused on regional banks within the United States, this ETF tracks the performance of the S&P Regional Banks Select Industry Index. It offers investors exposure to the dynamics of smaller regional banks, which can have distinct characteristics compared to their larger counterparts.
- Invesco KBW Bank ETF (KBWB): This ETF is designed to mirror the performance of the KBW Nasdaq Bank Index, focusing specifically on U.S. banking stocks. It provides concentrated exposure to a select group of larger banking companies.
Investors should make sure to conduct further research, as well as consider their investment goals and risk tolerance before committing to any ETF. While banking ETFs offer diversification and stability, it’s important to remain mindful of the ongoing fluctuations within the banking sector and the broader financial markets.
As the banking industry continues to navigate the aftermath of recent challenges, investing through well-structured and diversified ETFs will undoubtably provide a more prudent approach to capitalize on any potential opportunities while mitigating exposure to the inherent risks within the sector.
Should You Buy Bank Stocks Today?
Recent events have underscored the cyclical nature of banking, where economic fluctuations can significantly impact profitability and lead to mass bank failures.
The possibility of loan losses in commercial banking, sunk capital in investment banking during times of uncertainty, and the vulnerability to interest rate changes are all risks that investors must acknowledge when investing in the industry.
Despite these risks, the banking industry is also a place of resilience and adaptability. Rigorous stress tests and enhanced capitalization demonstrate a proactive approach to safeguarding against severe downturns. As well, the economic importance of banks throughout entire countries means these companies will continue to operate regardless of how high interest rates go or how much consumers decrease their spending.
For investors seeking exposure to the banking sector while mitigating risks, banking ETFs present a safer option than trying to pick individual regional bank stocks. These investment vehicles offer diversification across a range of the best bank stocks, reducing the impact of individual performance on your investment.
Notable banking ETFs such as XLF, IYF, KRE, and KBWB can provide a balanced and diversified approach to capitalizing on potential opportunities within the sector while not having to worry about choosing individual stocks in times of such high uncertainty.
Ultimately, the decision to buy bank stocks today hinges on your individual investment goals, risk appetite, and time horizon. It’s crucial to conduct thorough research, consult with financial advisors, and consider your portfolio’s broader diversification.
As the banking industry continues to navigate evolving economic conditions, a measured and thoughtful approach will empower you to make the decision that best aligns with your financial objectives.
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