Bank stocks are a very interesting security because the banks themselves lie at the heart of our economy. A bank's ability to make profits is generally tied directly to the current health of the economy, and more specifically, interest rates. However, banks are constantly expanding the ways in which they generate revenue, and this has made it considerably more difficult to determine the financial stability of a bank and the potential profits or risk of loss involved in investing in one.
This essay will look discuss some of the traditional and emerging factors driving a bank's stock prices and then look specifically at Wells Fargo as an example. Classically, banks made all their money through the difference between the interest they pay on deposits, and the interest charged for loaning that money back out to others. This mean that a bank's revenues were very dependent on interest rates as set by the FED, since higher rates means loans are less attractive to borrowers and therefore less opportunities for revenue for the bank.
Furthermore, high base interest rates would force the bank to consider narrowing their margin between interest paid for deposits and what was charged for loans. In general high interest rates also slow down the economy as a whole, which reduces the overall amount of investment and therefore borrowing. To combat their dependence on this single source of income, banks branched out (and are continuing to all the time) into more fee based businesses.
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By expanding to provide other financial services, such as insurance and trusts establishment, and adding fees to existing services like mortgages, banks have been able to overcome their direct reliance on interest as a revenue source. These services even go so far as the arrangement of loans which are then packaged into securities with an averaged risk and resold to other lending institutions. The bank then simply collects on the fees for establishing the initial loans and the securitization, without having to be concerned with deriving profits from the interest on the loans themselves.
This sort of securitized product is frequently called collateralized debt obligations or C. D. O. s and are very profitable business with generally little risk since the bank no longer owns the loans. These new avenues of income have helped banks separate themselves from their previous reliance on interest rates, and probably made them more profitable on the whole, but has this actually made the profitability of banks independent of interest rate fluctuations?
And furthermore, were banks profits ever truly as tied to the interest rates and we are led to believe. While it is traditionally thought that bank profits should fall as interest rates rites, one must consider investors that are in need of loans. When interest rates are rising, with further increases predicted for the future, people and businesses requiring loans will be clamoring to lock in a low rate before they get even higher.
This could mean the number of new loans opened could be as high or higher than that during periods of steady low interest (when investors think they have as much time as necessary to complete planning or other preperations before getting a loan). Beyond this, there is also the issue of securitization. If banks are able to package existing loans together and then sell them for a profit, while at the same time reducing their own risk, does that mean they are able to derive new profits from existing loans even when consumers are not opening new loans.
All of these issues bring up new questions about the structure and operation of modern banks. We will now turn our attention to a specific example, Wells Fargo in 2006 and 2007, in an attempt to uncover some answers about the modern banking industry and the determining factors in a banks profits and stock price, as well as a look at the change in bank asset quality of the past year as compared with 2006.
Remember. This is just a sample.
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