What economic indicators are important to consider when investing in the banking sector?

The banking sector is a hinge for nearly all economic activity. For that reason, there's hardly an economic indicator that doesn't relate to the banking industry. The most important indicators include interest rates, inflation, housing sales, and overall economic productivity and growth. Each bank investment decision should include an evaluation of the specific bank's fundamentals and financial health.

On one level, investing in the banking sector is just like investing in any other industry; you have to look for value among companies with solid future earnings prospects. Income investors want bank stocks that pay dividends, growth investors want bank stocks that are likely to appreciate.

If you look a little deeper, you'll find banking is a unique and vulnerable industry. The greater financial sector is often referred to as the lifeblood of the economy. Banks tend to thrive when the economy is booming, and they struggle when the economy is weak and loans dry up.

Falling asset prices – such as internet stocks in 2000 or housing prices in 2008 – spell trouble for banks that have leveraged inappropriately. This is particularly true when deregulation or financial innovation allow banks to assume unfamiliar risks. (For related reading, see "Bank Deregulation Could Cause Repeat of 2008 Crisis.")

Banks are uniquely sensitive to interest rate manipulations and lending practices by the Federal Reserve (the Fed). Bank stocks tend to perform best during easy money periods, when the Fed is pursuing expansionary monetary policy.

The Fed can provide cheap loans to member banks, bail out banks that are reckless with their lending practices or directly purchase bank assets to drive interest rates even lower. When monetary policy makes lending easier or less risky, expect banks to profit.

Among the most important Fed-driven indicators, investors should pay special attention to the money supply, real interest rates, inflation and the discount rate.

The cash reserve ratio is the percentage of funds banks have to keep on deposit and not lend out. This ratio, set by the Federal Reserve Board, determines how leveraged a bank is allowed to get. The normal ratio in the United States is 10%.

Just because banks are allowed to lend out 90% of their deposits doesn't mean they always do. Banks may restrict loans when times are uncertain, trading potential returns for security. But banks tend to earn more as they lend more, at least in the short run. (For related reading, see "Why Banks Don't Need Your Money to Make Loans.")

Economists and market analysts tend to track three main housing series: the number of dwellings started (construction), the number of dwelling projects completed, and the number of dwellings sold.

It's very expensive to build or buy a home. Nearly all housing projects require mortgages from banks or other lenders. Consequently, home sales and mortgage payments have a large effect on banking balance sheets. As 2008 showed, dropping housing prices and declining sales can cause many banks to struggle.

Since banking and financial intermediation connects a huge variety of market transactions, banks tend to see more business when the economy is growing. Investors can use gross domestic product (GDP) to determine current economic health and look at productivity levels as an indicator of the future economic health of the banking sector.

(For related reading, see "What Are the Main Benchmarks that Track the Banking Sector?")