A:

In a broad sense, bank share prices are driven by the same forces as any other shares. Major, abstract factors include overall market sentiment, expectations about the future, fundamental valuation and the demand for banking services. Banks are somewhat unique because central bank activity, such as Federal Reserve policy in the United States, plays a truly significant role in bank operations.

Stock valuation should always reflect the current health of a business and its future growth potential. For banks, this means being able to make healthy loans, to receive interest and fees on other accounts, and to limit counterparty risk.

Valuation Components

Investors use a wide variety of valuation methods (especially fundamental investors), but there are several underlying components that are universal, or nearly universal. These include assumed risks, expected growth, discounted future returns and the cost of capital.

Growth

Growth should be sustainable. Most fundamental and value investors look for dividends and various other accounting metrics to show growth potential. For banks in particular, monetary policy influences growth and profitability by manipulating interest rates. Sometimes -- such as after the financial crisis of 2007-2008 -- governments even directly issue extra capital to banks to prop up the financial sector.

Banks are likely to grow and produce profits by attracting depositors, making sustainable loans, issuing credit in other forms or making investments. Because the Federal Deposit Insurance Corporation (FDIC) guarantees depositors up to $250,000, much of the inherent risk for banks is alleviated.

Risks

Bank stocks are heavily influenced by three types of risk: interest rate risk, counterparty risk and regulatory risk.

A large majority of bank assets and liabilities are interest-rate sensitive. Generally speaking, banks look to maximize the amount of interest they generate from loans and minimize the interest they pay out on deposits. Keep in mind that deposits are liabilities and loans -- receivables -- are assets for banks.

A bank's assets are only as good as the debtors that it transacts with. When a mortgage or car loan is made, banks perform underwriting to ensure that the borrower can repay the loan. However, repayment certainty is very hard for investors to get a good sense of. Two banks, each with $100 million in loan receivables, may have very different counterparty risk exposure.

Bank regulation is a controversial topic. Many blame bank regulations for the vulnerability of U.S. banks before the Great Depression; still others blame deregulation for the financial crisis of 2007-08. Either way, bank share prices are sensitive to the perceived impact of changing government influence.

Earnings and Future Returns

Banks with higher price-to-earnings (P/E) ratios or higher price-to-book (P/B) values tend to have higher share prices. Since banks are highly leveraged by nature, it's very important for cash flow to be significant enough to cover short-term obligations.

Cost of Capital

Cost of capital is difficult to assess with banks, so it isn't entirely clear how much cost of capital is actually reflected in bank valuation. This is because most banks have a lot of off-balance sheet instruments and, in the U.S., a special lending relationship with the Federal Reserve.

The major source of bank capital comes from depositor accounts. During low interest rate environments, banks have to balance the lost cost of capital with the relative difficulty of attracting new deposits.

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