A:

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.

Why the Banking Sector Is Different

On one level, investing in the banking sector is just like investing in any other industry; 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.

Look a little deeper, and you'll find that 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 allow banks to assume unfamiliar risks.

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 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.

Cash Reserve Ratio and Credit Growth

The cash reserve ratio is the percentage of funds that banks have to keep on deposit and not lend out. This ratio, also set by the Fed Board, determines how leveraged a bank is allowed to get. The normal ratio in the United States is 10%.

Just because banks are allowed to lend out 90% of their deposits doesn't mean that they always do. Banks may restrict loans when times are uncertain. Banks that make fewer loans are trading potential returns for security. 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 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 the gross domestic product (GDP) to see current economic health and look at productivity levels as an indicator of future economic health.

RELATED FAQS
  1. What factors are the primary drivers of banks' share prices?

    Find out which factors are most important when determining the share price of banks and other lending institutions in the ... Read Answer >>
  2. What impact does the Federal Reserve have on a bank's profitability?

    Learn how the Federal Reserve impacts a bank's profitability with its influence on the discount rate, federal funds rate ... Read Answer >>
  3. What is the average profit margin for a company in the banking sector?

    Learn what the average profit margin is for companies in the banking sector, along with other evaluation metrics often used ... Read Answer >>
  4. How do leverage ratios help to regulate how much banks lend or invest?

    Learn what leverage ratios mean for banks, how regulators restrict leverage, and what impact ratios have on a bank's ability ... Read Answer >>
  5. What economic indicators are important for investing in the financial services sector?

    Read about some of the most important macroeconomic indicators that investors in the financial services sector should watch ... Read Answer >>
  6. What are the main reasons an investor should consider an allocation to the banking ...

    Learn about investment opportunities in the commercial and investment banking industry. Find out why many investors choose ... Read Answer >>
Related Articles
  1. Personal Finance

    Retail Banking Vs. Corporate Banking

    Retail banking is the visible face of banking to the general public. Corporate banking, also known as business banking, refers to the aspect of banking that deals with corporate customers.
  2. Insights

    The World's Top 10 Banks

    Learn more about the world's largest banks and how more financial power shifts eastward as China is home to four of the world's largest banks.
  3. Insights

    Overnight Rate

    Learn about how banks use this interest rate when lending to other banks.
  4. Insights

    Understanding the Bank Rate

    Bank rate is a term describing the interest rate a country’s central bank charges its domestic banks on loans it makes to them.
  5. Personal Finance

    How Banks Set Interest Rates on Your Loans

    Many factors go into how banks set interest rates for loans. Use this information to negotiate the best possible rate when you're borrowing.
  6. Investing

    Banking Stress Tests: Would Yours Pass?

    In weaker economic times, banks may be tested by the government to see how safe they are.
  7. Personal Finance

    Banking Has Changed: What Does It Mean For Consumers?

    Banks have long been leading spenders on technological innovations. Learn the key changes in the banking industry and what institution is right for you.
  8. Personal Finance

    Bank Profitability in the Era of Low Interest Rates

    The "low-for-long" policy on interest rates presents a major challenge to bank profitability.
  9. Investing

    What is a Bank?

    A bank is a financial institution licensed to receive deposits or issue new securities to the public.
RELATED TERMS
  1. National Bank

    In the United States, a commercial bank chartered by the comptroller ...
  2. Central Bank

    The entity responsible for overseeing the monetary system for ...
  3. Universal Banking

    A banking system in which banks provide a wide variety of financial ...
  4. Limited Service Bank

    Any type of banking business facility that is located separately ...
  5. Federal Reserve Credit

    Refers to the process of the Federal Reserve lending funds on ...
  6. Bankers' Bank

    A special type of bank that is created by a group of banks. Bankers' ...
Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Maintenance Margin

    The minimum amount of equity that must be maintained in a margin account. In the context of the NYSE and FINRA, after an ...
  3. Salvage Value

    The estimated value that an asset will realize upon its sale at the end of its useful life. The value is used in accounting ...
  4. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  5. Promissory Note

    A financial instrument that contains a written promise by one party to pay another party a definite sum of money either on ...
  6. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
Trading Center