As U.S. stocks turned volatile this month, big bank shares got especially wild. The Dow Jones U.S. Financials Index plunged 17% in August through the middle of last week before rebounding 8% by the close of trading Monday. During the same stretch, the Dow Jones Industrial Average lost 12% and gained 7%.

The bounce suggests investors don't expect a 2008-style collapse of the financial system. On that point, there's reason for optimism, but stability alone doesn't make the sector a good deal. Banks face two longer-term risks. The first is that they won't be able to grow. The second is that their importance within the economy may shrink.

The good news: The financial system has "more equity, more capital, stronger liquidity buffers and less leverage" than it did when Lehman Brothers collapsed, according to a recent research note from the banking trade group Securities Industry and Financial Markets Association (SIFMA). CreditSights, a research firm, agrees. Most big banks and brokers have "strong to very strong" liquidity, which would allow them to deal with a short-term emergency, it wrote Thursday in a note to clients.

 

Markets Hub: Banks Won't Fail, They'll Fizzle Out

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Smart Money's Jack Hough opines that certain levels of optimism during this downturn (opposed to 2008) will likely prevent banks from failing, but they're power will diminish over time. Photo: REUTERS/Fred Prouser/Files

Survival and growth are different things, however. Last week, with stocks plummeting and banks among the worst performers, JP Morgan chief executive Jamie Dimon offered CNBC viewers a shot of cheer. "[There's] a lot of uncertainty in the world out there, but we will still open branches tomorrow and hire bankers tomorrow and create clients tomorrow," he said. However, just a week earlier, his chief economist lowered the firm's third-quarter forecast for gross domestic product growth to a meager 1.5%.

"If the economy cannot grow more than 1% to 2% a year, that's not strong enough to get money flowing into the banking sector," says Todd Hagerman, a bank analyst with investment firm Sterne Agee & Leach. "The best banks can do in that environment is low single-digit growth, and that's not good enough to produce returns for shareholders."

Goldman Sachs last week lowered its growth forecast for U.S. growth domestic product to 1.7% this year and 2.1% next year.

In Hagerman's view, slow growth means consumers won't borrow and spend as much, and "for the most part the bread and butter for these companies is centered on the consumer." That's reason enough to remain bearish on the sector, he says.

There's another reason: Banks have benefitted from a half-century of rising financialization of the economy, where profits made through financial channels grow faster than those made through manufacturing and non-financial trade. After World War II, banks and insurance companies contributed 2.4% of gross domestic product. Last year, they contributed 8.4%.

Some financial instruments are unquestionably valuable for the economy. Mortgages allow workers to trade future labor for houses. Shares allow savers to participate in the growth of a diverse basket of companies. Less clear, however, is the enduring value of, say, speculative trading based on mortgage defaults, or speed-of-light stock trading based on computer algorithms. It's easy to view the past half-century as one of economic modernization, against which there's no going back. But research by Thomas Philippon, a finance professor at New York University's Stern School of Business, shows there has been surprisingly strong variation in the relative importance of banks in the economy.

The best periods for bank profits have been when economic growth is driven by the innovation of young, cash-poor companies, according to Philippon. Bank income swelled toward the end of the 19th century with the financing needs of railroads and heavy industry, and again during the 1920s as companies engaged in electric power delivery, car making and modern drug development sold shares to the public to raise capital. It peaked at around 6% of GDP before the Great Depression, but plunged to less than half that by the 1940s. The extraordinary profitability of banks a decade ago is explained by the financing needs of technology companies during the dotcom stock bubble. It's less clear why profits have since remained so high, however. In Philippon's view, services provided during the recent real estate bubble through high trading volumes and real estate derivatives were seemingly not worth the price.

That banks can weather recent events without buckling is good news for everyone. But stock buyers should remain cautious. At the least, banks will struggle to gain importance in a slowing economy. At worst for bank shareholders, financial services might revert from their recent role as star of the economy to their historic role of bit player.