Four Reasons to Buy Bank Stocks During a Recession

Though well over a decade ago, memories of the last real recession—the Great Financial Crisis (GFC)—still linger when it comes to buying bank stocks. Banks were the epicenter of the GFC and, as regulators forced them to re-capitalize due to loan losses, their shares fared poorly. Now, with the threat of another recession on the horizon, even some professional money managers are finding it hard to ignore their “flight” instinct to flee from small bank stocks.

While understandable, this innate response has set up a very attractive entry point for astute investors willing to buck sentiment and buy banks stocks during a recession. Here are four reasons why now may be an opportune time to buy the stocks of US community banks:

#1 Recession Is Already Priced In

Some asset classes seem to be pricing in the chance of a modest recession. But a recession appears to be guaranteed judging by the valuation levels of smaller banks. Consider that community bank stocks have only traded at their current price to tangible book values¹ twice during the last three decades—briefly in 2020 at the outset of the pandemic and during the GFC (Display). Even during the 2001 recession and when recessionary fears rose in the rising rate cycle of the mid-1990s, community bank stocks troughed at valuations well above current levels. Essentially, when it comes to community bank stocks, the market is not just pricing in a recession—it’s pricing in a major recession.

#2 US Banks Seem Ready This Time 

Many stock sectors have endured negative earning revisions this year in the face of rising rates and slowing global growth. Yet US banks continue to see positive earning revisions and still operate at strong levels of profitability. A key reason? When short-term interest rates rise, most banks’ spread-lending (as measured by their Net Interest Margin²) becomes more profitable. That’s because they can drag their feet when it comes to paying more for deposits while immediately charging more for loans (Display). Most investors expect the Fed to continue raising short rates over the next several meetings. In other words, the improved 2023 earnings picture for US banks is coming from a place of strength, while other sectors deteriorate. On a relative basis, that may make some investors more willing to buy bank stocks during a recession.

At the same time, we foresee US bank balance sheets remaining resilient should the Fed’s stance push the US economy into recession. Coming out of the GFC, bank management teams—and their regulators—have strengthened loan underwriting. This time, the excesses are originating from outside the system, among fin-tech and other non-banks, and in sectors such as “buy-now-pay-later,” non-prime auto, and leveraged lending. 

What’s more, US banks have not materially released loan loss reserves this time around, despite relatively stringent underwriting standards. That leaves a healthy cushion to absorb loan losses should they begin to rise from today’s very low levels (especially for smaller banks, which have historically seen only about half the loan loss rates of their larger peers). Similarly, US bank equity cushions sit at historically high levels going into a potential downturn, making the likelihood of bank failures—or even equity re-capitalizations—extremely low. In fact, small banks have announced take-outs (sales of their company) at an annualized rate of 3.5% so far this year, which is very close to the 3.6% take-out pace for both 2021 and for the prior 5-year period as a whole (2017–2021).³

#3 US Banks Are Likely to Stay Profitable—and Drive Book Values Higher

While it may strike some as a bold claim, it’s less audacious than it seems. The GFC remains the only recession in the past 35 years where US banks across the board have been unprofitable for a single year. For example, according to FDIC reports, industry-wide Return on Equity (ROE) was 7% in 2020, 13% in 2001, and 6% in 1991—three challenging periods for the banking sector. How does that compare to today? In totality, US banks delivered an ROE of 11% in the first half of 2022—a figure we expect to rise over the next six quarters. Ultimately, investors shouldn’t let profitability concerns prevent them from seizing the moment to buy bank stocks during a recession. 

#4 Expect Excess Returns as We Emerge from a Recession 

Up until now, banks have not had a chance to put investors’ GFC concerns to rest, once and for all. But as recessionary fears fade—and US banks remain quite profitable (though not at the expense of asset quality and balance sheet strength)—they can finally emerge from the shadow of their pre-GFC predecessors. From there, we can make a solid case for US bank stocks to re-capture their historical valuation multiples. For smaller community banks, the upside from this valuation re-capture is potentially quite significant. What’s more, the stocks should achieve these normalized multiples on much higher book values than today, compounding the return for investors that buy microcap banks at current levels.

Are Bank Stocks a Good Buy?

While sentiment may remain weak until a recession ultimately hits, we view this as an attractive time to build a position in community bank stocks. We expect bank stocks to grow their book values from here, and institutions that choose to sell in the meantime are likely to garner a significant M&A premium. Waiting for the “all clear” risks missing out on much of the valuation re-capture, as well as other meaningful sources of return between now and then.