The banking sector did relatively well in 2021 as the global economy rebounded from the Covid-19 pandemic. The SPDR Financial ETF rose by almost 30% between January and August, while the S&P 500 rose by less than 20%.
SPDR Financial ETF vs. S&P 500 performance comparison
Therefore, this article will look at how to invest in bank stocks and some of the key metrics to look at.
Types of banking stocks
First, we need to look at several types of banking stocks. Furthermore, a bank like Goldman Sachs is significantly different from a small bank like Zions Bancorp. So, let us look at the several types of banking groups in the US.
- Holding banks – These are companies that have several subsidiaries or businesses that do different things in the market. For example, JP Morgan is both an investment bank and retail lending. Other examples of these banks are Morgan Stanley and Citigroup.
- Commercial bank – A commercial bank is a financial institution that provides deposits and lending services to consumers and businesses. Examples are Trust Financial and PNC Financial.
- Wealth management – These are banks that target wealthy individuals and pension firms. Most of these companies are parts of bigger banks like UBS, Credit Suisse, Morgan Stanley, and Julius Baer.
- Regional banks – These are companies that provide banking solutions to specific regions of the country. Examples are Silvergate Capital, First Republic Bank, and Zions Corporation.
- Investment banks – These are banks that provide investment solutions to pension funds and other wealth management firms. Examples are Moelis, Perella Weinberg, Lazard, and Evercore.
- Neobanks – These are relatively new banks that provide solutions to retail and businesses. Many of them are private banks. The biggest ones are Marcus, NuBank, and Dave.
- Mortgage banks – These are banks that provide mortgages to individuals and companies. Most of them are part of holding banks. Examples of the biggest mortgage banks are Rocket Companies and Loan Depot.
How banks make money
An important rule when investing in a stock is to identify how the company makes money. For example, when you are investing in Apple, you should know that the firm makes money by selling the iPhone, iPad, iWatch, and other services. Similarly, when you are investing in a bank, you need to understand how it makes money.
As seen above, banks are not the same, meaning that they all make money differently. Commercial banks make money by taking customer deposits and lending them out to other customers. In this case, they will take the deposits and keep them safe.
In most cases, the banks pay a small amount of interest to the customer. At the same time, they lend money at a bigger rate and pocket the difference. Therefore, these firms make more money when interest rates are higher. They also make money from ATM withdrawals.
Holding banks like Goldman Sachs and Morgan Stanley have many sources of income. Let us look at Goldman Sachs. The bank makes money by offering investment advice to companies, such as during mergers and acquisitions. The firm also makes money by investing and trading in fixed income, stocks, currencies, and commodities. Additionally, it owns Marcus, a company that provides banking solutions to customers. Further, it is also a wealth manager that provides advisory services.
Mortgage banks, on the other hand, make money by providing mortgages and then receiving monthly payments over a long period. Some neobanks make money through a subscription service.
Key metrics to know when investing in banks
Banks are different companies from firms like consumer staples, discretionary, and technology firms. Therefore, you should look at several things when investing in bank stocks.
- Revenue growth – Ideally, you should focus on banks that have stable revenue growth. This is usually a signal that the bank is expanding its market share.
- Loan growth – For companies that provide loans to consumers or businesses, you should look at how they are growing their loan books.
- CET Ratio – The Common Equity Tier is an important number that shows the stability of a bank by showing whether it is well-funded. It is calculated by taking its core capital in relation to the risk-weighted assets. A higher ratio means that the bank is well-capitalized, meaning that it will be in a good position to increase its payouts.
- Key ratios – There are some key ratios that are mostly specific to banks, like efficiency ratio, leverage ratio, and provision for credit losses ratio.
Investing in Banking ETFs
There are two main ways of investing in banking stocks. First, you can invest in a single banking stock like Morgan Stanley and Goldman Sachs. As you will find out, most similar banks tend to move in the same direction.
For example, when one bank rises, the other ones will typically rise. The chart below shows that Goldman Sachs, Morgan Stanley, Bank of America, and JP Morgan tend to move in the same direction.
JPM, GS, MS, and Bank of America performance comparison
The next alternative is to invest in bank exchange-traded funds (ETF). An ETF is a financial product made up of several assets. In this case, you can invest in ETFs that track different types of banks.
For example, if you want exposure to regional banks. The SPDR Regional Banks ETF tracks most regional banks in the S&P 500. Some of its biggest constituent companies are Silvergate Capital, First Republic Bank, Pinnacle Capital Partners, and Western Alliance Bancorp.
Alternatively, you can invest in an ETF that tracks the biggest global banking groups. In this case, you can invest in a fund like the iShares Global Financial ETF. You can also invest in bank ETFs by geography. For example, the iShares Europe Banks ETF gives you access to the biggest banks in Europe.
Banks are usually some of the most popular financial institutions in most countries. The banks provide other companies like those in the oil and gas, agricultural, and insurance firms with the liquidity to do business. However, they are also risky since they are highly regulated and affected by changes in interest rates. Therefore, you should have a relatively small exposure to the industry, preferably in the form of ETFs.