It's easy to forget now given that stock prices are at all-time highs, but there were fears of a financial crisis in the spring. Part of it was some PTSD from the Great Recession when problems in the banking system paralyzed many parts of the economy. But, there were also other "red flags" like credit spreads blowing out, lending coming to a halt, and selling in safe-haven assets.

The Federal Reserve attacked these issues with aggression by injecting tremendous amounts of liquidity into markets, bringing back programs from the financial crisis, cutting rates to zero, and restarting asset purchases. It also placed stricter capital requirements on banks including a temporary halt on share buybacks and limits on dividends.

Loosening of Regulations

However, after the banks passed the Fed's second stress test, these limits were loosened. It's another sign of the economy recovering and that the worst of the crisis is behind us. If anything, it could be argued that banks have been too cautious as they set aside billions in loan-loss reserves. This led to earnings being weak during Q2 and Q3 but could lead to stronger earnings in future quarters if the default rate is lower than expected which seems likely if the recovery continues.

Following the Fed's decision, JPMorgan (JPM  ) announced a $30 billion in share buybacks. Many expect that more share buybacks and dividend increases could be announced in Q1.

Stock Price Outlook

The news caused bank stocks to soar. Many of them broke out to new post-pandemic highs. The news is good on two fronts - it makes shares more attractive since more money will be returned to shareholders and it's a vote of confidence from the Fed that the banking system is sound.

The Fed conducts stress tests to ensure that banks will be able to keep lending even in adverse situations, however, there was a real-life stress test due to the coronavirus with economic activity coming to a temporary halt. The banks seem to have passed it with flying colors.

Looking forward, the bank stocks look quite attractive if one believes that the economy will keep recovering. Strong housing prices mean that defaults are likely to remain low. Due to the stimulus, household balance sheets are in remarkably good shape. The Fed is going to keep rates at zero percent in 2021 which means that if the economy keeps recovering, the yield curve will steepen which will lead to more profits for banks.

In terms of valuation, bank stocks are quite cheap. The sector has been out of favor for years. Yet, they've consistently compounded earnings and grown via acquisitions. The best-performing sectors enjoy multiple expansion and earnings growth. Both seem plausible for banks in 2021.