3 Reasons I Don't Invest In Financial Stocks: A Former Regulator's Perspective

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Includes: GS, JPM, WFC
by: Kevin Jacques

Summary

Financial crises are inevitable, and financial institutions have trouble measuring risk.

Changing Dodd-Frank will have unintended consequences that may increase risk.

Even without changes to Dodd-Frank, the risk to bank stocks is likely underestimated by investors.

Depending on changes made to Dodd-Frank, risk in the financial system may increase.

Let me begin with two disclosures. First, I am a dividend growth investor with a long-term perspective and have been for a number of years. Second, I spent 14 years as a former economist with the U.S. Department of the Treasury in Washington, D.C. My first 10 years, I was with the Office of the Comptroller of the Currency (the bank regulatory arm of Treasury), and the last four years, I worked at Treasury headquarters advising members of President George W. Bush's Administration. My primary work during those 14 years involved bank regulation and capital standards, risk measurement and management, and systemic risk.

With that said I woke up Friday morning (February 3) to the headline in the Wall Street Journal that said, "Trump Moves to Undo Dodd-Frank". That got me thinking about financial stocks and, like many investors, I've noted the movements in bank and financial stocks since the November election. With the potential dismantling of Dodd-Frank, some of these stocks look quite attractive going forward. For example, Wells Fargo (NYSE:WFC) has a dividend yield of just over 2.6% with a dividend that has grown from $0.20 in 2010 to $1.52 today. Goldman Sachs (NYSE:GS) stock price has almost tripled since 2008, and JPMorgan (NYSE:JPM) has a trailing P/E of less than 15. But to be honest I don't own any bank or financial stocks in my portfolio and likely never will. Let me give you three reasons why:

  1. There will be another financial crisis

With or without Dodd-Frank, there will be another financial crisis. I don't know what will cause it or when it will occur (I'm not that smart), but I know one will occur. I'm not alone in saying this, as former Federal Reserve chairman Alan Greenspan has made similar comments. The reason is simple. Financial regulators can regulate or monitor all kinds of risk in the financial system: market risk, credit risk, interest rate risk, etc. But what they can't regulate is the human factor whether that be fear or greed or hubris or arrogance. Regulators can't stop investors from being "irrationally exuberant" or stop institutions from thinking they are smarter than the markets. Human emotion is a powerful driver of markets and market behavior, but predicting the human element and its impact on financial markets is incredibly difficult. And that makes predicting future financial crises (and ultimately the stocks of financial institutions) tenuous at best.

  1. Financial institutions have trouble measuring risk

Despite all the advances in computer technology and big data, financial institutions still have trouble measuring risk. I will never forget back in the 1990s going to a large Wall Street financial institution with a team of others from the Treasury Department. We were meeting to talk about foreign exchange rate (FX) risk, and when we asked them how much FX risk they were currently taking in their portfolio, they couldn't tell us. Rather, they said they could tell us in a few days. Now while things might be better today, for those of you who haven't already, I encourage you to read The Quants by Scott Patterson. As recently as the 2008 Financial Crisis, some of the best financial modelers got it very, very wrong.

Why does this problem arise? It occurs because risk models are generally built to assess risk under normal market conditions. But financial markets are subject to wild, unpredictable swings as they often exhibit leptokurtosis. Leptokurtosis is a fancy way of saying large but damaging events, ones which should occur extremely rarely, but occur far more frequently than predicted by traditional finance theory. Today, when talking about these events, we often refer to them as black swans from the book of the same title by Nassim Taleb. What all this means for financial institutions is that they (and their stock prices) are far more vulnerable to large negative shocks than implied by traditional financial theory.

  1. Unintended consequences

Whether we are talking about increasing regulation or deregulating the financial system, changing the rules by which the financial system plays will bring forth unintended consequences. I've seen it firsthand. For example, much of what occurred during the most recent financial crisis was an unintended consequence of numerous political and regulatory decisions regarding mortgages and home ownership put in place in the years and even decades leading up to the crisis. Part of the reason unintended consequences occur is because regulators often build one-size-fits-all rules for financial institutions. Part of it occurs because regulators don't have perfect knowledge of how financial markets and institutions will respond to changes in regulation. And part of it occurs because politics injects itself into the regulatory process, whether that be by deciding what regulators can or can't do or by applying political pressure into how regulations are applied.

So why not bank and financial stocks?

Despite some very attractive characteristics and what appears to be a more friendly regulatory environment going forward, I don't invest in bank or financial stocks for my portfolio. Dismantling Dodd-Frank will bring with it unintended consequences. For example, to regulators, capital serves as a cushion to absorb unexpected losses. Reducing capital ratios required under Dodd-Frank may make banks less safe by reducing the size of their cushion. Or, if the Administration eliminates some of the other powers granted to regulators in Dodd-Frank, banks will be able to take more risk and the government will be less able to resolve financial crises when they occur. Furthermore, this dismantling process will largely be done by politicians and political appointees and may take years to fully complete.

What does this mean for bank and financial stocks? Financial institutions already have enough trouble measuring and managing risk. And financial crises are inevitable. Recall that during the 2008 Financial Crisis, a number of large banks had to be saved by the government. And some of those that didn't need to be saved saw huge declines in their stock prices as well as required reductions in the dividends they paid to shareholders. Even without changes to Dodd-Frank, the risk to bank stocks is likely underestimated by investors. And while there are certainly significant benefits to be achieved by dismantling selected parts of Dodd-Frank, if politicians don't do it carefully and with foresight toward the safety and soundness of the U.S. financial system, then it may significantly increase the risk to our financial institutions and their shareholders. As a long-term investor, I believe the risks are too great for the rewards.

To readers: Most of the articles I write for Seeking Alpha involve estimating the monthly risk profile of the S&P 500 Index, with an emphasis on estimating the probability of negative tail risk. If you would like to read those simulation results, or are interested in future articles about economic and financial policy, please click on the follow button at the top of this article next to my name.

Disclaimer: The views expressed are those of the author and nothing in this article should be construed as advice specific to your portfolio.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.