A sector in the spotlight: Investing in the banking sector

Why you should remain wary of banking stock bargains in the wake of Silicon Valley Bank’s collapse.

Banks play an important role in the economy. Not only do they hold our money, but they make lending possible so we can expand our businesses or buy our dream home. 

This significance is underpinned by Government action in times of turmoil. For example, in 2008 both the US and UK Governments bailed out some of the world’s largest banks during the financial crisis. Not many other sectors would receive such attention.

So, given their role in keeping the economy running, should you consider adding banking stocks to your portfolio? And are the stocks of some of the biggest banks currently cheap after the collapse of Silicon Valley Bank (SVB)?

Below we explain some of the key considerations you’ll need to make if you have plans to invest your money in the banking sector.

Before we dive into the current state of the banking sector, it’s important to understand how banks earn their money.

While retail banks, which offer savings and lending products to the public, rely on a variety of different income streams many of these institutions depend on interest as a source of income.  

To explain how this works, consider this example. You decide to open a current account with your bank and make a deposit of £5,000. In return, your bank promises to pay a rate of interest on your balance.

To generate this interest, it takes some of your £5,000 deposit as a source of borrowing for loans, mortgages and overdrafts, among other products. Over time it receives this money back with interest.

Part of this interest is filtered back into your current account while the rest is kept as profit.

Other types of banks, like investment banks, have different business models. An investment bank doesn’t cater to the average consumer and instead offers a range of financial services to businesses. It could, therefore, earn most of its money through fees and commission structures.

This goes to show that the revenue structure of each bank differs. So, when investing in the banking sector, you should spend some time investigating how one specific company earns its money in more detail.

To look at a bank in more detail, a great place to start is by looking at its balance sheet.

If you’re looking at investing in a retail bank, one of the first things you can look for is how much money it has set aside to cover “bad debt” over the upcoming year. This is borrowing it has made and doesn’t expect to be paid back. 

If you do end up investing in a retail bank, then it’s worth keeping this figure in mind. If the bank has overestimated the amount it expects to write off then some of this provisioned money can be reinvested into the business and could create better profits.

Granted, in isolation expected write-offs don’t paint an overall picture of a bank’s health. So, you could compare this expense in proportion to its expected income.

If your bank relies on making money from the interest it charges, it’s worth looking at the net interest margin. This is the difference between the interest it pays for deposits, such as on savings and current accounts, and the interest it receives from borrowing, such as through mortgages and loans. 

Looking back at Lloyds Bank’s annual results in February, it registered an increase in its net interest margin from 2.54% to 2.94% over the year.

Richard Hunter, Head of Markets at interactive investor, said that this helped net income rise by 14%.

“The continued strength of the Lloyds’ significant mortgage book was again in evidence, with loans overall rising by £6.3 billion to £455 billion for the period,” he said.

These are just two takes you can look at as a DIY investor if you’re interested in investing in the banking sector. There are multiple other indices you can use to measure the health of a banking stock.

The banking sector is a significant part of the European stock market. According to Hargreaves Lansdown, an investment company, HSBC, Lloyds Banking Group, NatWest, Barclays and Standard Chartered make up a third of the entire market value of European listed companies.

Of these companies, HSBC, Lloyds Bank and Barclays Bank are some of the biggest banks by market capitalisation on the FTSE 100.

HSBC, which recently acquired SVB’s UK holding for £1, is known for operating internationally. According to its website, it operates in 62 different countries in Europe, Asia, the Middle East, Africa, North America and Latin America. Back in the UK, it also owns other recognisable brands such as first direct and M&S Bank.

Lloyds Bank, meanwhile, is known for owning Halifax, the UK’s largest mortgage lender. This means it could be an investment to consider if you’re looking for exposure to the UK’s property market.

Then there’s Barclays Bank, one of the oldest high street banks in the country. It’s played a role in banking innovation over the past century by releasing the first debit card and ATM in the UK.

When investing in the banking sector it’s important to note the role monetary policy has on its performance.

Monetary policy is a term used to describe the actions central banks take to control the economy. This can range from quantitative easing to raising interest rates, which are both explained in more detail in our guides.

But looking at raising interest rates in particular, some analysts argue that a high bank base rate environment benefits the banking sector. The idea is that an increased base rate means banks can charge more for loans, mortgages and other forms of borrowing and widen their net interest margins. This increases their profit margins, which can lead to a better dividend payout.  

While there is an element of truth to this idea, it’s perhaps too basic because there are other variables at play. For example, if central banks raise rates too quickly it can lower the demand for borrowing, which means the banks will be lending less and therefore making less profit.    

Plus, more expensive borrowing puts some borrowers at risk of default. When this happens banks could be forced to write the debt off, further affecting their profits.

It’s no secret that the banking sector has been subject to volatility since the collapse of SVB earlier this month. As investors feared these issues would spread across the banking sector, equities have suffered.

On Friday, the FTSE 100 finished 5.3% lower than the previous week, according to Morningstar, a financial services company.

“Banks in London were largely in the red at the close on Friday. HSBC, NatWest, Lloyds, Barclays and Standard Chartered were down 2.9%, 1.4%, 2.6%, 2.0% and 2.5%, [for the trading day] respectively,” Morningstar said in an article on Friday.

Meanwhile, the Swiss Government forced through a takeover of Credit Suisse by rival UBS , which has further impacted the volatility of banking stocks.

“It has been a fraught fortnight for the banking sector with the collapse of SVB, and the turmoil at Credit Suisse. Investors clearly remain extremely cautious towards the sector,” said Victoria Scholar, Head of Investment, interactive investor.

She then explained that banks, financial services and insurance are the worst performing sectors across Europe.

Given the volatility in the banking sector, you could easily think that investors have overreacted to recent events and that banking stocks are cheap. But this belief that a banking stocks bargain can be picked up amid the instability carries significant risk.

The value of these stocks could drop further, especially given that it’s still unclear if the banking sector has felt the full effect of SVB’s collapse and remains unstable

So, if you’re currently thinking about investing in the banking sector, remember that your investments might be exposed to further fluctuations.

Susannah Streeter, Head of Money and Markets at Hargreaves Lansdown, shared a similar sentiment.

“It is not yet known exactly where more pain will emerge in the banking sector, but investors fear the problems are not yet over,” she said.