Is it still too risky to invest in banking stocks?

Thanks to tighter regulations, the banking sector is more attractive to investors than the dark days of the financial crisis. But tread with caution and expect lower returns, say analysts

Illustration by Alex Belman

It is now more than a decade since the financial crisis blew up and we are all still living with the consequences.

Interest rates remain at record lows, trillions in monetary stimulus continues to wash around the system, the global debt mountain is larger than ever, and despite an eight-year stock market bull run most investors still shun banking stocks.

The big banks remain reviled for gambling with depositors’ money then demanding taxpayers bail them out after the collapse of Lehman Brothers threatened to destroy the global financial system.

People still loathe the “greedy bankers", and given the constant stream of rate-rigging and mis-selling scandals since the crisis, that is unlikely to change.

However, the last decade has also seen a massive regulatory assault on the sector, as the authorities launch a determined bid to avoid a repeat of the banking meltdown.

Regulators have ditched the pre-crisis “light touch” model in favour of a far more rigorous system with demanding capital and liquidity requirements.

Rob James, co-manager of the Old Mutual Financials Contingent Capital Fund, says the new rules are steadily rebuilding credibility. “Banks now hold double the amount of capital relative to the risks they are taking. In the UK, for example, core equity tier 1 ratios have risen from between 5 to 7 per cent before the financial crisis to between 13 and 15 per cent today.”

The banking system is almost unrecognisable and this also limits the danger of contagion if one bank fails. “Balance sheets are cleaner and smaller, capital and liquidity levels higher, regulation tighter, and backstops more encompassing,” Mr James adds.

He says this finally makes the banks investable again, but safety measures mean investors should expect lower returns than before. “Pre-crisis returns were illusory, a function of leverage. They should be more stable in future.”

Darren Preston, head of equity research at European Wealth Group, says years of rock bottom interest rates have squeezed banks’ net interest margins, which measure the difference between what banks pay to attract savings and other deposits, and what they charge to lend money via mortgages and loans.

This should change as global interest rates finally start rising, with the US Federal Reserve leading the way. "Higher rates should allow banks to expand net interest margins and boost profitability, and banking stocks should be a beneficiary,” he says.

Investors must still approach with caution, Mr Preston adds. “While many have significantly improved their balance sheets with huge write-offs, capital raising and restructuring, others remain uninvestible.”

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European banks

Mr Preston is particularly wary of Europe, where many banks remain under-capitalised and loaded with bad debt. "Europe has more than a few "zombie" banks, as we saw with the Italian and Portuguese bailouts. For now, we put continental European banks in the ‘too risky’ pot.”

Russ Mould, investment director at online platform AJ Bell, also warns against risky Italian banks, but says Germany’s Commerzbank looks cheap relative to the value of its underlying assets. “BNP Paribas in France, Denmark’s Danske Bank and Nordic bank Nordea are also promising, and feature in mutual funds such as Baring European Growth, BlackRock European Dynamic and Artemis European Opportunities.”

Sotiris Boutsis, portfolio manager of the FF Global Financial Services Fund says Europe is attractive as eurozone interest rates are set to climb from today’s zero per cent, provided you select your stocks carefully. “CaixaBank, Société Générale and Intesa Sanpaolo will benefit from higher rates," he adds.

Tread carefully

Before investing in any individual bank, Mr Preston says you must first understand its business model. “Some are simple creatures focused on small business and personal banking, while others are more diverse with exposure to riskier activities such as investment banking.”

Investment banking can produce generous profits in the good times, but is volatile in times of trouble. "It can be feast or famine," Mr Preston says.

Investors looking for a simple "vanilla" bank should consider Lloyds Banking Group in the UK, he says. This has a relatively low risk profile but is starting to pay generous dividends. It currently yields 4 per cent but this is forecast to hit 6.7 per cent in 2018.

You must also expect some share price volatility, with the stock trading 16 per cent lower than three years ago, partly due to "legacy issues" such as a major insurance mis-selling scandal which has cost it more than $50 billion in customer compensation. Brexit is also a concern for this domestic-focused bank.

Higher risk options

Mr Preston says those happy to accept a higher level of risk might consider Sberbank of Russia, which recently posted record third-quarter profit growth as its net income rose 62 per cent year-on-year to 222 billion rubles (USD $3.68 billion). “Despite sanctions and turmoil in the Russian economy and banking sector, it has continued to deliver excellent results. In fact, it has benefited from the turmoil, attracting more deposits as customers see it as secure, boosting its net interest margins,” he says.

Sberbank has scope for further rapid growth as the Russian economy improves and more Russians take out mortgages, he says.

Figures from Bloomberg show the share price leapt 48 per the last year, it yields 2.6 per cent but with a fast increasing dividend, and trades on a low valuation of 6.9 times earnings (15 times is usually seen as fair value).

“Sberbank might appeal to long-term investors who are not put off by the political risk,” Mr Preston adds.

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US banks

Mr Mould says Western banks operate in mature, tightly regulated and highly competitive markets and may struggle to grow quickly as a result. “They are also under pressure from the growing financial technology, or ‘fintech’ sector, as smaller challenger banks look to take market share by offering either app-based banking or better personal customer service."

Mr Mould says US banks were faster to clean up their act after the crisis than their British or European counterparts, and look stronger as a result.

However, investment banks JP Morgan Chase, Goldman Sachs and Bank of America posted disappointing results lately, as current low financial market volatility makes trading harder. “All three have strong franchises and will be eagerly waiting to see what President Donald Trump's administration does in terms of deregulation, as this could potentially lower their costs and increase earnings,” says Mr Mould.

Mr Boutsis of the FF Global Financial Services fund, sees opportunities in select large cap names in the US, as the government looks to reduce compliance costs and ease existing regulations. “Bank of America and JPMorgan stand to benefit from such a scenario. We also rate Citigroup,” he says.

UK banks

UK banks Barclays also retains a large investment banking arm but its shares trades 12 per cent lower than a year ago, and are down 18 per cent over five years, while it yields just 1.58 per cent, Mr Mould says. “The latest slide in Barclays’ share price suggests investors are not entirely happy about chief executive Jes Staley’s plan to invest heavily in risky investment banking, volatile area.”

HSBC is listed in London but earns 90 per cent of its revenues overseas, primarily in China, and is seen as a tempting play on country. It now yields 5.38 per cent but any slowdown in China could hit it hard. In November its private banking unit was fined a record $51 million over sales of structured products linked to Lehman Brothers in Hong Kong, just the latest in a constant string of regulatory fines that continue to rock the sector and hit profitability. Every bank remains vulnerable.

Mr Mould says London-listed Standard Chartered also has massive Asian exposure and is now in recovery mode after a profit slump. “This may be a good long-term banking play, even if the pace of its operational turnaround under chief executive Bill Winters has disappointed some, judging by reaction to its third-quarter results.”

What to avoid

He urges investors to stand clear of the notorious Royal Bank of Scotland (RBS), still 73 per cent owned by the UK taxpayer after a £60bn bailout in 2008. “RBS remains an impenetrably vast and complex organisation so is only suited to risk-tolerant investors.”

In contrast Mr Boutsis sees an opportunity. “RBS is now close to putting its legacy issues behind it and has scope for optimising its capital and funding structure,” he says.

Mr Mould says a banking scandal is never far away, with US bank Wells Fargo a recent faller after it emerged that employees had created millions of false bank accounts to hit sales targets. Its share price crashed, but is now recovering.

High levels of consumer and corporate debt are another challenge for Western banks, as this makes further lending risky.

Mr Mould says emerging market banks may perform better as consumer debt levels are much lower, while a growing middle class will need more financial services products. "You need to be careful as there are question marks hanging over Chinese banks in particular as substantial debts pile up in state-owned enterprises and the bubbly property market.”

Alternative approaches

Mr Mould suggests investing in a fund instead, which spreads your risk by giving you exposure to a wider number of banks. “The Fidelity Asia Fund has a good selection of banks in its top 10 stock holdings, including India’s HDFC, China’s Industrial and Commercial Bank and Singapore’s United Overseas Bank,” he says.

Sam Instone, director of financial advisers AES International in Dubai, urges private investors to approach stock picking with extreme caution. "Whether a bank is a good bet comes down to the quality of the underlying loans in its portfolio, which is impossible for individuals to gauge. You also need to look at factors such as price to tangible book value, return on assets, return on equity, and the efficiency ratio, to name just a few.”

Performance figures suggest that individual stock pickers are also prone to make basic mistakes, such as selling winning investments while holding onto losing ones, and putting too much faith in past performance.

Nobody doubts that investing in individual stocks is dangerous, and individual banking stocks even more so.

There are exciting opportunities as the banking sector finally stabilises, but plenty of threats remain. You can bank on it.