The recent failures of Silicon Valley Bank, Signature Bank (OTC: SBNY), and First Republic (NYSE: FRC) and the poor performance of other regional banks serve as a reminder of the underappreciated risks of investing in bank stocks. It’s not just the inherent banking risks that should make investors selective in buying bank stocks. The historical relative performance of bank stocks should also cause consternation for investors.
Key Takeaways
Fractional reserve banking allows banks, not the Fed or government, to create money.
Banks typically only have an approximate 10% equity cushion supporting their assets.
Such leverage creates bankruptcy risk if banks are not hedged properly for interest rate and credit risk.
Bank stocks have underperformed conservative sectors and the broader S&P 500 (ARCA: SPY).
Despite the broad risks, there are good banks that can be investment worthy.
Fractional Reserve Banking
All money is lent into existence.
Read that sentence as many times as it takes to grasp. Its understanding is critical to understanding the U.S. banking system.
Despite what the media or financial pundits may say, banks, not the Fed or government, create money!
Under the fractional reserve banking system, on which America’s financial system operates, money is “created” via loans. Here is a simple example:
You deposit $1,000 into a bank.
Your neighbor borrows $900 from the same bank to buy a TV from Costco.
The bank holds the remaining $100 as reserves.
Costco deposits the $900 into its account at the same bank.
The bank turns around and lends $810 of Costco’s $900 deposit.
The cycle continues as money multiplies despite the actual cash in the financial system remaining at $1,000.
Whether or not your neighbor pays back the $900, you and Costco have a combined $1,900 in your accounts. In this case, the $900 the bank created via the loan to your neighbor is new money out of thin air.
Fractional reserve banking, as we diagram, works well until there is a bank run and or enough loans are defaulted upon or lose sufficient value.
Bank Balance Sheets
We examine the aggregate balance sheet for all U.S. commercial banks to take fractional reserve banking to a working level and appreciate why small and mid-sized banks are struggling.
As the graph shows, commercial banks hold about $23 trillion in assets against $20.8 trillion in liabilities. The difference, $2.2 trillion, is the banking sector’s equity. The yellow shading represents the implied leverage ratio. ...Full story available on Benzinga.com
Related tickers: FRC.
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