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Investing in the safest banks has historically been very lucrative.
They have high returns on equity and can dig economic moats around their businesses in the form of high switching costs. Changing banks is a hassle, and most consumers don’t bother to take out assets even if they find a competitor that offers slightly better rates.
Except for large conglomerates and investment banks, banking is a simple business. They borrow money at a very low rate through deposits, and lend money at a higher rate to people who need mortgage loans, personal loans, auto loans, student loans, and lines of credit. For a well-managed bank, it’s not too hard to keep their deposit balance going up each year, which allows for consistent annual growth.
In fact, Warren Buffett made most of his fortune by investing in banks and insurance companies.
But all investors today should remember the financial crisis for the rest of their investing careers. The recession threw institutions that were once thought to be nearly invincible into sudden insolvency. And residential real estate, the asset class that as once thought to be extraordinarily safe, crashed. Even the most well-run banks cut their dividends and hunkered down for survival.
But those most well-run banks survived, and eventually flourished during the recovery, giving shareholders great returns over the past decade despite the financial crisis occurring during the period.
The U.S. Federal Reserve now stress-tests all of the largest banks to ensure that they are well-capitalized. And see if they are able to survive a recession even more severe than the one that we went through in 2008. They force banks to use less leverage than they did before, and most banks take it upon themselves to have stricter underwriting standards for their loans and take risk more seriously.
June 2017 Bank Stress Test Results
In June, the Federal Reserve released this year’s stress test report, and for the first time, all 34 banks on their list passed. Only one bank, Capital One, was given “conditional” approval, and the rest were given a full green light.
