Should bank shares belong in my portfolio?

Over the past few years, the volatility in the price of most bank stocks has made shareholders rather nervous. Yet many investors still include banks in their portfolios due to their relatively high dividends. 

Today, I’d like to discuss the cyclical as well as long-term factors that I believe may drive the price of bank stocks, to help interested readers make better-informed decisions when trying to separate winner shares from the losers.  

Types of banks and their incomes

Banks provide a wide range of financial products and services. For centuries, commercial banking activities, namely deposit-taking and granting of loans, have been their most important operations.

For such commercial banks, their liabilities are largely in the form of deposits, which are available to their creditors or depositors on demand. On the other hand, their assets often take the form of loans that have longer maturities.

Such banks earn income on loans and other interest-earning assets. They pay interest on deposits and other interest-bearing liabilities. As we evaluate its balance sheet, we can arrive at a bank’s net interest income (NII) by deducting interest paid from the total interest earned. 

Today, many banks have a hybrid model that allows them to generate about half of their revenue from non-interest bearing activities. These include fees from investment and brokerage services, banking-related service charges, credit card-related fees, trading profit and losses, mortgage-related activities and increasingly fees from mobile banking operations.

Industry fundamentals

There are several fundamental factors that affect the industry. They include:

• Economy (both national and global), such as interest rates, business cycles and property prices.
• Politics, for example trade wars between nations and government responses to referendums, such as Brexit.
• Regulation, such as mis-sold payment protection insurance (PPI) claims.
• Technology, such as cybersecurity issues or the increased use of mobile banking online.
• Societal developments, such as demographic changes that may also affect technological decisions a bank takes.
• Geographical concerns, such as over-exposure to a specific country or geography which may affect a bank’s income due to economic developments or currency exchange rate fluctuations.

Of these factors, most analysts would rate the economy as the most important one. And among the economic factors for banks, the first one to discuss is interest rates.

After the economic recession and financial crisis of 2008, central banks in the UK, eurozone and US have stimulated economic growth by cutting interest rates to near zero, and thereby reducing the cost of borrowing for households and businesses.

Because banks do a large amount of the lending to those borrowers, their profitability is negatively affected by low rates, as they reduce their margins. 

Strong economic growth is crucial for the performance of banks. The City agrees that since late 2016, the UK’s economic activity has been impacted by the uncertainty around Brexit.

In a strong economy, as consumer and business spending increases, the rate of inflation begins to rise. In order to keep inflation under control, central banks may raise interest rates. Then cost of borrowing becomes more expensive. However margins, and therefore profitability, for lenders increase.