Analysing... Banks

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It is one of the longstanding rules of the old 'sector rotation' theory of investing that shares in banks and other financial companies are the first to outperform when a new bull market starts in earnest.

The reason is that lower short-term interest rates and a steepening yield curve tend to be good for conventional banks, which 'borrow short' and 'lend long'.

The mixing up of investment bank and traditional banking businesses over the last two decades, and the recent credit induced debacle, has meant that in recent years the old rules may not have held true. In future, the wings of investment bankers may be well clipped, and traditional ratios for assessing banks may come more to the fore.

Looking closely at the ratios in banks' annual accounts may be boring. But for shareholders in the long gone Northern Rock, HBOS, Alliance & Leicester and Bradford & Bingley it would, in hindsight, have highlighted their vulnerability to a drying up in the market for wholesale funding.

Analysing bank shares is inevitably a numbers game. There are several well-worn ratios that provide an insight into the business.

One is the so-called 'efficiency ratio'.

This compares non-interest expense to total income. Most of a bank's expenses are, or should be, the cost of funding the loans they make. This either consists of interest rates paid to depositors, or the cost of wholesale funding in the money market. But equally important is that they keep other non-interest related expenses in check. This is what the ratio measures. The lower the number, the better it is. The expectation should be that it is less than 60%, and perhaps even less than 50%.

Return on assets and return on equity are also important measures.

These are calculated as they would be on any other company, with post-tax profits measured against average shareholders' equity. Ideally in this case, the number should be greater than 15% for the bank to be creating some value for shareholders.

Return on assets is a trickier number, though. This is because a bank's assets are the loans it makes and therefore its assets will dwarf shareholders' equity and hence the return on average assets, though positive, will more than likely be a low single-figure percentage.

Next comes the 'capital adequacy' ratio.

There are various rules regarding bank solvency, and different tiers of capital that are included and excluded according to various official yardsticks. A simple way of looking at capital adequacy, however, is to compare shareholders' equity with total assets. The numbers will vary, but a bank that has a capital adequacy number of less than 8-10% would traditionally have been said to be overextending itself.

Looking at loans

Another way of measuring the soundness of a traditional banks' business used to be to look at loan loss provisions as a percentage of total loans, where the number should be less than 1% and where any marked increase in the percentage from year to year would be questionable.

An analogous measure is to compare the increase in loans from one year to the next with the increase in loan loss provisions. An increase in loans that is dramatically outstripped by an increase in provisions suggests undue risks are being taken on new business.

A related ratio is the percentage of 'non-performing' loans to total loans.

Non-performing loans are those where there are arrears of interest or capital repayments. Obviously, the lower the percentage of these the better it is for the bank. In an ideal world this ratio would be less than 1%.

Measures like this have, however, been compromised in recent years by the securitisation of loans and their distribution to other banks. This has adversely affected the ability to measure these ratios accurately and also affected the control the banks have over non-performing loans which may have originated elsewhere.

Another basic measure of bank soundness is the interest rate spread - the difference between interest received and interest paid; in effect a traditional bank's gross margin. Banks may well disclose this in their accounts and a spread of three percentage points is probably a good yardstick for ongoing financial health. What's best is to look at the different net interest margins between banks with similar businesses. Those with higher margins tend to be better managed.

Peter says

This is a brief snapshot of some of the ratios that are important to bank investors.

If, as seems likely, banks return to more traditional ways of doing business these calculations may become more important. Certainly professional investors are likely to look at banks in a more disciplined and rigorous way than they have in the past and private investors should do the same. These ratios should help to do that.

There are two final comments to make. The first is a caveat. Many banks, particularly those with large non-traditional businesses like investment banking and securities services, have a sizeable chunk of profits flowing from speculative share and bond trading and corporate finance fees, custody fees and the like. These are not susceptible to the same degree of analysis. Some, like custody income, are stable. Others, like trading income, are inherently unstable.

The second observation is that bankers, even traditional ones, are prone to rushes of enthusiasm. Examples are plentiful, whether it is lending to South American governments, lending to highly leveraged buyouts, investing in businesses, buying up investment banks, or securitised loans and trading credit default swaps. These bandwagons have almost always led to disaster.

The time to invest in banks is when they have been sufficiently chastened by the aftermath of the latest debacle to proceed (or be forced to proceed) cautiously for a while.