Investing in banking stocks and shares can be very profitable. While the industry is not known for delivering immense growth, these financial stocks have a reputation for high dividend yields as well as providing stability.

This stock market sector is actually at the heart of most economies. Despite their morally questionable behaviour in some instances, financial institutions provide essential access to capital for both consumers and businesses alike.

With that in mind, let’s explore these companies in more detail, going over their potential and risks.

What are Banking Stocks?

Banking stocks, or shares as we tend to call them in the UK, refer to any company involved in the financial sector directly or indirectly. These financial institutions are licensed to receive and hold deposits or loan money out to individuals and businesses.

However, despite what the name suggests, this industry is not restricted to commercial banks. It also includes other services such as credit unions, asset management companies, insurance firms and the like.

• Commercial – This is the most common type of financial institution. Commercial banking offers personal bank accounts, mortgages, safe-deposit boxes, and credit cards are some of the most common services these banking shares offer. Here in the UK, the largest commercial bank is Lloyds. And across the pond in America, Wells Fargo and JPMorgan Chase lead the charge.
• Retail – These companies are similar to Commercial Banks. However, the key difference is that they deal directly with retailers that render financial services to their clients. This is where groups like Bank of America and Citibank reside.
• Investment – These banks play advisory roles in complex financial transactions. They are middlemen/ intermediaries who advise individuals, businesses and governments when they want to undertake such transactions. Consumers can’t deposit any money with these firms. But suppose a company is in the market for an IPO, acquisitions, mergers, wealth management, or general market research. In that case, these are the companies to turn to. Some of the largest banking shares in this area would be Morgan Stanley and Deutsche Bank.
• Insurance Providers – This category contains any business that offers compensation to policyholders in the event of something going wrong. Policyholders typically pay a recurring monthly or annual premium in exchange for financial protection should the worst comes to pass. There are countless types of policies available depending on which insurance provider someone goes to. But the most common include home, travel, car, health, and life insurance. Examples of insurance companies are Aviva plc and All States Insurance Group. 
• Brokerages – These firms connect buyers and sellers to carry out a transaction. This could be the sale of securities, loans, or even real estate. All investors should be familiar with at least one brokerage firm since they are an essential middleman that facilities all their investment transactions. Some leading companies in this domain are TD Ameritrade and Fidelity Investments.

What are the Main Risks to Investing in Banking Shares?

Investing in banking stocks and shares is a popular move by investors seeking stability. Yet despite the high barriers to entry and complex nature of running these businesses, banking stocks often have to face off against immense competition. This can place a lot of pressure on profit margins, especially during times of economic distress.

But even after ignoring the competitive landscape, there remains a more prominent threat to these firms- bad debt. For most companies, debt is a liability that needs to be paid off over time. For banks, debt is an asset. But these assets only have value if the customer can repay the loan as agreed. If the bank cannot correctly assess the lending risk of a potential client, it could result in several large loans being issued that may never be repaid.

Fintech stocks have also started becoming a more pronounced threat as the digitalisation of personal banking continues to gain popularity amongst younger generations.

I do not doubt that financial institutions like banks will continue to exist for decades to come. After all, their services are critical for businesses to thrive. However, with continuous innovation coming out from other companies, it’s difficult to discern what banking shares might look like in a few decades.

These groups also have some reputational tarnishes, especially after the 2008 financial crisis. Yet while new regulations are undoubtedly improved the ethics surrounding this industry, there are still some dubious practices still deployed.

Key Financial Metrics 

Assessing the performance of banking shares can be a little tricky due to the complex nature of these institutions. However, in my experience, it’s possible to get a good assessment of what’s going on under the surface by tracking a few key metrics.

• Interest Income – This is the earnings generated from receiving interest payments from customers that have borrowed capital. Banks often lend out capital to customers at an agreed-upon interest rate using other customers’ deposits as well as internal investments.
• Net Interest Income – This is the difference between the interest income a bank earns from its lending activities and the interest it pays to depositors.
• Net Asset Value – This represents a fund per-share intrinsic value. This is the difference between the book value of an institution’s assets and the value of its liabilities.
• Net Profit Margin – Represents the degree of profitability a bank has after all its activities. On average, banking stocks typically have a net profit margin of around 32% in the United States and 22% in Europe.
• Cost to Income Ratio – This is used to know a financial institution’s efficiency and profitability. The lower the ratio, the better.

Key Terms when Investing in Bank stocks

Banking shares can have quite a few confusing terms thrown about in regulatory filings. But it’s important for a prospective investor to understand these terms. So, let’s clarify some of the common offenders.

• Dividends – This is the part of a company’s profit that choose to distribute to investors. Typically these are paid out either every quarter or every two quarters. The frequency of distribution is at the discretion of management.
• Assets – Refers to what a company owns that has the potential to appreciate in value over time. Assets have earning potential for a company.
• Investment Trust – This is a financial institution that pools funds from its shareholders and invests the fund on behalf of its shareholders in diversified portfolios or securities. 
• Inflation – This is the increase in the price of goods and services in an economy. Inflation also reduces the purchasing power of a given currency.
• IPO (Initial Public Offering) – This is the first time a financial institution offers its stocks to the public. IPO goes with the listing of a company’s stock on a stock exchange.
• Merger – This simply refers to the coming together of two companies to form a single entity.

What is the Market Size? 

North America is the largest region in global investment banking, with a 46% market share. In 2020, Asia Pacific was the second largest region accounting for 26% of the global investment market, while Eastern Europe remains the smallest. And with the tragic geopolitical conflict currently escalating in Ukraine, that’s unlikely to change anytime soon, I feel.

According to a report by Research and Markets, the global investment banking market stood at $102.84bn in 2020 before reaching $111.45bn in 2021. Moving forward, the industry is expected to continue growing at a respectable 5% annual compounded rate.

But investment banking is only a small part of the financial sector. Another report by Research and Markets points to some rapid expansion in the global open banking segment. In 2020, the market size stood at around $15.13bn before rising to $15.13bn in 2021. This double-digit climb isn’t expected to slow down either, with annualised growth forecasts standing at 25.7% until 2025. That sort of growth certainly makes investing in banking stocks, and shares sound like a promising idea for my portfolio. At least, that’s what I think.

Once again, North America is leading the charge. However, the Asia Pacific region of the world is actually where most of the growth is expected to come from moving forward.

Top Banking Stocks in the UK by Market Capitalisation

Below are the top five banking stocks listed on the London Stock Exchange in order of market capitalisation.

Top Banking Stocks in the US by Market Capitalisation

Below of the top five banking shares listed on the New York Stock Exchange in order of market capitalisation.

Should I Buy Banking Stocks for my Portfolio?

The banking sector is the backbone of the global economy as the need of the various financial institutions therein cannot be overemphasised. The unquestionable demand for such services in the future makes investing in banking stocks and shares an attractive proposition for my portfolio.

Having said that, these companies are not immune to failure or moral hazards. The financial crisis in 2008 serves as a perfect example of why some investors rightfully detest this sector. Personally, I believe the good that these institutions enable is more significant than the harm they’ve caused in the past. But any investment I make into this sector will be diversified across multiple banking stocks to reduce my risk level.

Prosper Ambaka does not own shares in any of the companies mentioned. The Money Cog does not own shares in the companies mentioned at the time of publishing. Views expressed on the companies and assets mentioned in this article are those of the writer and therefore may differ from the opinions of analysts in The Money Cog Premium services.