Banks stand out from the rest of the sectors, in terms of how they make money.
Banks make money from money.
Banks get deposits from customers promising an interest rate, and lend that money at a higher interest rate – the difference goes to its pocket. Simple? I bet it’s not that simple.
How do you determine whether a particular banking stock is a good one or not? How do you forecast their financials? How do you value them? Read on to find out.
Let’s start with understanding banks’ financial statements. This is key to understanding banks, and are much different from other sectors’ financials.
Bank balance sheets are much more liquid than other businesses. Look at the below sample. See the major items, and compare them to shareholders’ equity. Super-leveraged, isn’t it? That’s a bank’s biggest risk.
Source: Wells Fargo
Industrial companies make money by deploying their fixed assets, buying raw materials and selling them. Banks just manage their balance sheet to make money.
In banking, money is the raw material.
Let’s look at some of the key items in the balance sheet:
Loans and advances to customers: This constitutes the single biggest asset, and the primary money making machine. The amount that appears in the balance sheet is after providing for credit losses and allowances.
Investments in securities: Apart from the obvious reason of getting interest income, investment portfolio is primarily to manage liquidity and balance credit risk from loan portfolio. Hence banks mainly favor investing in government bonds and highly-rated corporate bonds – due to higher liquidity and lower credit risk. Equity investment exposures are hardly made, or are very small. In some countries (like India), there are regulations that mandate holding a certain percentage of deposits in government bonds.
Fixed assets: Fixed assets are only a tiny portion of a bank’s total assets. Most fixed assets will be in the form of computers etc. Buildings for retail and back-office operations are mostly taken on lease.
Deposits from customers: This is the biggest item on the liability side, and is the source of majority of banks’ funding base. There are, as you know, three types of deposits – fixed/ time deposits, and CASA (current and savings accounts). Since CASA deposits are very cheap, banks having a higher proportion of such deposits tend to generate higher margins. Retail customer deposits are the most stable form of funding, and is the most desirable as well.
Debt issuances and certificate of deposits: Banks with weaker retail funding franchise resort to wholesale funding in the form of issuing debt papers. The risk here is that the funds are costlier, and funding can dry up in times of liquidity crisis, unlike retail deposits.
By now, you would have noticed that most of the bank’s assets and liabilities are liquid, and are quoted in the balance sheet at close to market values. This brings us to a major point in bank valuation:
Banks are valued based on book values.
I emphasized ‘based’, and not ‘at’. Current book values does not consider future growth potential, as well as the return on equity. We will capture these metrics into valuation using a derivation of Gordon Growth Model (GGM), to arrive at a target price-to-book:
Target P/B = (RoE-g)/(CoE-g)
Source: Wells Fargo
Net interest income (NII): This is the largest revenue line for banks. NII is the difference between interest income and interest expense. As you know, interest income is influenced by amount of interest yielding assets and yield on assets. And interest income is influenced by amount of interest bearing liabilities and cost of liabilities.
The difference between yield on assets and cost of liabilities is called ‘spread’ – a measure of the cut banks makes from borrowed funds.
The key metric of lending operations is called ‘Net Interest Margin (NIM)’ – this is calculated as follows:
NIM = NII / Average interest earning assets
To simplify, NIM is the percentage margin on every dollar lent.
As we will see later, higher NIM should not be evaluated in isolation.
NIM > Spread
Why is that?
This is because there are interest free funds with the banks – which belong to the shareholder. On these funds, the entire yield goes into the income statement without any recorded cost.
NIM is the most influential ratio of them all – just a 5 bps change in NIM can swing the profits by a big amount.
Generally speaking, increasing interest rate environment will help in expanding NIM. This is because, deposit costs tend to lag increase in lending yields. There are two reasons for this – (1) Fixed deposits will take time to mature and get repriced, (2) Current and savings account have very low costs and will only marginally rise.
Fee income: Fee includes the incomes on brokerage business, credit/debit card fee, commissions on services such as bank guarantees, insurance commissions, fund management fees etc. Of late, income from wealth management franchise has become a key revenue stream for banks, especially in developed markets.
Other incomes: This includes fee from forex trading, gains on sale of securities etc.
Operating expenses: Costs such as employee costs, rent, depreciation and other costs associated with running businesses are included here. Cost-to-income ratio – measured by operating expenses divided by total operating revenue – is the metric used to measure how efficiently the operations are run by the bank.
Provision for loan losses: This is the line where the bank provides for lending that could be unrecoverable. The bank should continuously assess the credit risk of each loan, and provide for the extent to which they are unrecoverable. Some central banks mandate the extent to which they should provide for. Basically, this line item is the cost of bearing the credit risk. The key metric used to evaluate such cost is called ‘credit cost’:
Credit cost = Provision for credit losses / Average amount lent
Credit costs are the second most important ratio in income statement, next only to NIM. There is another link between NIM and credit costs. Banks that take on more risk and lend at higher rates tend to record high NIMs. But, this could be partly offset by the credit costs, due to the higher riskiness of losses. Hence high NIMs should be seen in the light of risk of higher credit costs in the future.
Cash flow statement
The cash flow statement of banks are not evaluated by investors. Why is that?
This is due to the fact that free cash flows for a bank cannot be computed. There are two key reasons for this:
- Reinvestment for future growth, or capex in the traditional sense is not applicable for banks. For banks, reinvestment is all about building the brand image – which is captured through operating expenses. Banks rarely invest in office space.
- Net working capital changes, again in the traditional sense, is highly volatile. WC for banks include loans and deposits. These WC changes does not have any relationship with future growth or cash flows.
Hence FCF cannot be computed, and there lies the difficulty in valuing banks based on DCF.
We already discussed some of the key ratios above. Let’s see all of them together, along with other important ones.
- Net interest margin
- Loan and Deposit growth
- Loan to Deposit ratio
- Fee revenues to total revenues
- Cost to income ratio
- Credit costs
- Impaired loan ratio, or NPL %
- Provision coverage for NPLs
- Regulatory capital ratios
Banks are high leverage businesses. Look at the total equity, and see how much multiple of it is the total assets. On an average, it is around 10x. That’s huge! Compare this to non-banking businesses, and you will see how leveraged banks are.
This is exactly the reason why central banks mandate minimum capital requirements:
- Common Equity Tier 1 (CET1)
- Tier 1
- Total capital adequacy
There are some more requirements like Liquidity coverage ratio (LCR), Net stable funding ratio (NSFR) etc.
Generally, central banks around the world go in sync with the requirements laid out by Basel Committee on Banking Supervision (BCBS). The latest standard is Basel 3, and people have already started talking about Basel 4.
Don’t get confused with the details here. Just understand that there are some minimum capital requirements. The higher the capital ratio, the better (as you already figured out).
Those banks with lower capital adequacy ratios will face restrictions from the central bank – in terms of dividend pay outs. Also, there is a risk of capital dilution, as such banks need to raise capital to strengthen capital base.
Banks are very different from other businesses in almost every sense. I hope that I have been able to help you get a hang of how banks should be evaluated. Let me know through comments, if you find something difficult to understand.