Are bank stocks back? Maybe. Just looking at recent performance from some of the financial sector’s biggest names, it’s hard to argue that banks aren’t on the rebound.
What’s more: the Federal Reserve just announced the results of its latest “stress tests” on banks — allowing many banks increase their dividends or buy back shares. Considering that JPMorgan already boasts a healthy 2.4% dividend yield and was just granted another nickle per quarter in its payout, this could make some financial stocks serious players among income investors once more.
But as the old saying goes, past performance is no guarantee of future returns. So before investors go jumping into bank stocks, they should take a hard look at the risks and rewards of the financial sector.
In fact, the question isn’t whether banks are safe stocks, since all equities pose a substantial level of risk right now. A better question is whether banks are safe enough for your specific investment strategy. After all, persistently high unemployment, debt woes in Europe and Washington and fears of a slowdown in China are just a few macroeconomic challenges that could take the wind out of any sector — and financials are no different.
Only you can decide whether the risks outweigh the rewards. But to help you make that decision, here are the five biggest problems and the five biggest opportunities facing big financial stocks right now:
Risks to Big Bank Stocks
New Capital Requirements Limit Banks: At the core of most uncertainty is the recent regulatory push. Global banking safeguards regarding higher levels of capital reserves (so-called “Basel 2” and “Basel 3” rules) force financial institutions to hold a larger amount of cash on the balance sheet — preventing them from actively using that money to grow profits via lending or investing. It also has to be “high-quality” capital, not just paper and IOUs, in the event that another economic shock forces banks to tap into that cash. Whether this is a needed move for global banking stability or an overreach of regulators is academic — when these safeguards roll out in the years ahead with a full implementation deadline of 2015, you can understand how they will create a drag on earnings.
Volcker Rule: Equally troublesome for banks is a ban on proprietary trading (the so-called “Volcker Rule”) so companies can’t play the market with house money. Consider that in Q2 of 2009, Bank of America raked in a cool $6.7 billion in just three months from its trading operations. Under strict interpretation of the proposed ban on trading, not a penny of those profits would have existed. When you back out billions in trading revenue from bank earnings — especially while consumer and business lending remains anemic — it creates rather unimpressive numbers for major financial stocks.