Investing in the safest banks has historically been very lucrative.
They have high returns on equity, and can dig economic moats around their businesses in the form of high switching costs. Changing banks is a hassle, and most consumers don’t bother to take out assets even if they find a competitor that offers slightly better rates.
Except for large conglomerates and investment banks, banking is a simple business. They borrow money at a very low rate through deposits, and lend money at a higher rate to people who need mortgage loans, personal loans, auto loans, student loans, and lines of credit. For a well-managed bank, it’s not too hard to keep their deposit balance going up each year, which allows for consistent annual growth.
In fact, Warren Buffett made most of his fortune by investing in banks and insurance companies.
But all investors today should remember the financial crisis for the rest of their investing careers. The recession threw institutions that were once thought to be nearly invincible into sudden insolvency. And residential real estate, the asset class that as once thought to be extraordinarily safe, crashed. Even the most well-run banks cut their dividends and hunkered down for survival.
But those most well-run banks survived, and eventually flourished during the recovery, giving shareholders great returns over the past decade despite the financial crisis occurring during the period.
The U.S. Federal Reserve now stress-tests all of the largest banks to ensure that they are well-capitalized. And see if they are able to survive a recession even more severe than the one that we went through in 2008. They force banks to use less leverage than they did before, and most banks take it upon themselves to have stricter underwriting standards for their loans and take risk more seriously.
June 2017 Bank Stress Test Results
In June, the Federal Reserve released this year’s stress test report, and for the first time, all 34 banks on their list passed. Only one bank, Capital One, was given “conditional” approval, and the rest were given a full green light.
The report breaks down the results of each bank, so if you’re bank investor, it’s a must-read. They simulate an extremely severe recession, and model the impact on each bank to see if they would remain solvent and able to continue to lend even through the darkest times.
Specifically, these are the economic conditions they use:
- The unemployment rate goes up to 10%
- GDP falls by 6.5% from its pre-recession peak
- Equity prices fall 50%
- Residential real estate prices fall 25%
- Commercial real estate prices fall 35%
- International developed markets face severe economic recessions as well
Probably the most useful chart in the report is this one:
This chart shows the percentage of their total loans that each bank is expected to lose under such a severe scenario.
Discover (NYSE: DIS), Capital One (NYSE: COF), and American Express (NYSE: AXP) have the highest expected loss rates. You might assume it’s due to poor underwriting standards, but that’s actually not the case. In particular, American Express and Discover are among the most conservative underwriters compared to their peers.
Instead, the divergence among banks is mostly due to the type of lending they do.
American Express and Discover are the most heavily focused on credit card lending. Credit cards have the highest loss rates during recessions. Wells Fargo (NYSE: WFC), on the other hand, is heavily in the mortgage space, which is less volatile and less prone to losses.
The most pure-play custodian banks such as State Street (NYSE: STT) and The Bank of New York Mellon (NYSE: BK, commonly called BNY Mellon) have the lowest expected loan loss rates, and hardly any expected absolute loan losses at all. This is because they don’t participate in normal consumer banking like most other ones on the list do.
The Safest Banks Come at a Price Premium
There’s no free lunch, and the banks with the lowest expected loan losses tend to command the highest valuations on their stocks, as measured by the price-to-earnings (P/E) ratio.
- State Street and BNY Mellon have P/E ratios of about 17 and 16, respectively.
- U.S. Bancorp (NYSE: USB) and Fifth Third Bancorp (NASDAQ: FITB) have P/E ratios of 16 and 14.
- Capital One and Discover have P/E ratios of under 13 and 11.
The pure-play custodial banks and the most diversified large banks, especially U.S. Bancorp, have the highest credit ratings as well.
Since all 34 banks passed the stress test, they all have enough equity to withstand the expected loan losses, at least according to the Federal Reserve.
For example, American Express has the third highest percentage of expected loan losses. It’s estimated to lose almost $11 billion worth of loans in this severe scenario. But they have almost $21 billion in equity to absorb that potential hit.
The banks with the higher expected loan losses tend to have less leverage, because they need that extra capital to cushion their more volatile lending activities. This is how, for example, Discover managed to remain solvent during the financial collapse despite being an almost pure-play credit card lender.
All 34 banks on the list are considered well-capitalized against foreseeable risks, but for some of them a recession would give them a bumpier ride as big chunks of their equity get cut away by loan losses. American Express and Discover have had rather bearish performance over the last few years; both of them currently have a stock price lower than they had in 2014. Investing in some of the more volatile picks takes a bit of a contrarian mindset, but both of them are rather attractively priced at the moment.
When you’re looking for a bank to invest in, the key question to ask yourself is what degree of volatility and uncertainty you’re willing to handle. An aggressive lender like Capital One is fairly diverse, but still has substantial credit card exposure and uses some of the loosest lending standards with high net loan charge-offs. American Express and Discover are the most focused on credit cards, but maintain strict underwriting standards.
Some banks, like the custodial pure-plays and the banks that are both diversified and conservative, like U.S. Bancorp, are expected to be the safest and least volatile, but may offer lower total returns in exchange for that safety.
Disclosure: The author owns shares of Discover Financial Services.