The banking sector is a hinge for nearly all economic activity. For that reason, there's hardly an economic indicator that doesn't relate to the banking industry. The most important indicators include interest rates, inflation, housing sales, and overall economic productivity and growth. Each bank investment decision should include an evaluation of the specific bank's fundamentals and financial health.

Key Takeaways

  • The banking sector touches almost all parts of an economy, therefore most economic indicators are applicable to analyzing bank investments.
  • The primary economic indicators to pay attention to when evaluating the banking sector are interest rates, inflation, housing sales, and overall economic productivity and growth.
  • Like any investment, the first step in evaluating a bank investment is determining if you are interested in income stocks that pay dividends or growth stocks that will likely appreciate.
  • Assess the interest rate environment established by the central bank; banks tend to perform better during an expansionary monetary policy phase.
  • Pay attention to the reserve ratio requirement that the Fed sets for banks, determining how much money they can loan out, which directly relates to profits.
  • When the housing market is booming, banks tend to do well, as companies need loans to build homes, and consumers need loans to buy them.
  • In general, when gross domestic product (GDP) is on the rise, all industries will perform better, including banks.

Why the Banking Sector Is Different

On one level, investing in the banking sector is just like investing in any other industry; you have to look for value among companies with solid future earnings prospects. Income investors want bank stocks that pay dividends, growth investors want bank stocks that are likely to appreciate.

If you look a little deeper, you'll find banking is a unique and vulnerable industry. The greater financial sector is often referred to as the lifeblood of the economy. Banks tend to thrive when the economy is booming, and they struggle when the economy is weak and loans dry up.

Falling asset prices—such as internet stocks in 2000 or housing prices in 2008—spell trouble for banks that have leveraged inappropriately. This is particularly true when deregulation or financial innovation allows banks to assume unfamiliar risks.

The following points are key indicators to consider before investing in the banking sector.

Monetary Policy

Banks are uniquely sensitive to interest rate manipulations and lending practices by the Federal Reserve (the Fed). Bank stocks tend to perform best during easy money periods when the Fed is pursuing an expansionary monetary policy.

The Fed can provide cheap loans to member banks, bail out banks that are reckless with their lending practices, or directly purchase bank assets to drive interest rates even lower. When monetary policy makes lending easier or less risky, expect banks to profit.

Among the most important Fed-driven indicators, investors should pay special attention to the money supply, real interest rates, inflation, and the discount rate.

Reserve Requirement and Credit Growth

The reserve ratio is the percentage of funds banks have to keep on deposit and not lend out. This ratio, set by the Federal Reserve Board, known as the reserve requirement, determines how leveraged a bank is allowed to get. The normal ratio in the United States is 10%, however, this was reduced to zero in March 2020 during the Coronavirus pandemic.

Just because banks are allowed to lend out 90% of their deposits in a regular environment doesn't mean they always do. Banks may restrict loans when times are uncertain, trading potential returns for security. But banks tend to earn more as they lend more, at least in the short run.

Housing Development and Home Sales

Economists and market analysts tend to track three main housing series: the number of dwellings started (construction), the number of dwelling projects completed, and the number of dwellings sold.

It's very expensive to build or buy a home. Nearly all housing projects require mortgages from banks or other lenders. Consequently, home sales and mortgage payments have a large effect on banking balance sheets. As 2008 showed, dropping housing prices and declining sales can cause many banks to struggle.

Gross Domestic Product (GDP) and Productivity

Since banking and financial intermediation connects a huge variety of market transactions, banks tend to see more business when the economy is growing. Investors can use gross domestic product (GDP) to determine current economic health and look at productivity levels as an indicator of the future economic health of the banking sector.

The traditional definition of a recession is two consecutive quarters of GDP decline.

In general, when GDP is on the rise, the entire economy is doing well. When GDP is flat or in decline, it signals economic trouble.

The Bottom Line

The banking sector is one of the largest sectors in an economy, playing a crucial role in most industries. Because its reach is far and wide, there are many economic indicators that directly relate to it and, therefore, can indicate its health or poor performance.

Important areas to consider include gross domestic product (GDP), housing sales, new home builds, and actions taken by the Fed, such as monetary policy, which includes the adjustment of interest rates and the reserve requirement.