ByStephen D. Simpson, CFA
As banks have very different operating structures than regular industrial companies, it stands to reason that investors have a different set of fundamental factors to consider, when evaluating banks. This is not meant as an exhaustive or complete list of the financial details an investor needs to consider, when contemplating a bank investment.
For many banks, loan growth is as important as revenue growth to most industrial companies. The trouble with loan growth is that it is very difficult for an outside investor to evaluate the quality of the borrowers that the bank is serving. Above-average loan growth can mean that the bank has targeted attractive new markets, or has a low-cost capital base that allows it to charge less for its loans. On the other hand, above average loan growth can also mean that a bank is pricing its money more cheaply, loosening its credit standards or somehow encouraging borrowers to move over their business.
As previously discussed, deposits are the most common, and almost always the cheapest, source of loanable funds for banks. Accordingly, deposit growth gives investors a sense of how much lending a bank can do. There are some important factors to consider with this number. First, the cost of those funds is important; a bank that grows its deposits by offering more generous rates, is not in the same competitive position as a bank that can produce the same deposit growth at lower rates. Also, deposit growth has to be analyzed in the context of loan growth and the bank management's plans for loan growth. Accumulating deposits, particularly at higher rates, is actually bad for earnings if the bank cannot profitably deploy those funds.
The loan/deposit ratio helps assess a bank's liquidity, and by extension, the aggressiveness of the bank's management. If the loan/deposit ratio is too high, the bank could be vulnerable to any sudden adverse changes in its deposit base. Conversely, if the loan/deposit ratio is too low, the bank is holding on to unproductive capital and earning less than it should.
A bank's efficiency ratio is essentially equivalent to a regular company's operating margin, in that it measures how much the bank pays on operating expenses, like marketing and salaries. By and large, lower is better.
There are a host of ratios that bank regulators and investors use to assess how risky a bank's balance sheet is, and the degree to which the bank is vulnerable to an unexpected increase in bad loans. A bank's Tier 1 capital ratio takes a bank's equity capital and disclosed reserves and divides it by the bank's risk-weighted assets, (assets whose value is reduced by certain statutory amounts, based upon its perceived riskiness).
The capital adequacy ratio is the sum of Tier 1 and Tier 2 capital, divided by the sum of risk-weighted assets. The tangible equity ratio takes the bank's equity, subtracts intangible assets, goodwill and preferred stock equity, and then divides it by the bank's tangible assets. Although not an especially popular ratio prior to the 2007/2008 credit crisis, it does offer a good measure of the degree of loss a bank can withstand, before wiping out shareholder equity.
Capital ratios can be thought of as proxies for a bank's margin of error. Nowadays, capital ratios also play a larger role in determining whether regulators will sign off on acquisitions and dividend payments.
Return On Equity / Return On Assets
Returns on equity and assets are well-established metrics long used in fundamental analysis across a wide range of industries. Return on equity is especially useful in the valuation of banks, as traditional cash flow models can be very difficult to construct for financial companies, and return-on-equity models can offer similar information.
The importance of credit quality ratios is somewhat self-explanatory. If a bank's credit quality is in decline because of non-performing loans and assets and/or charge-offs increases, the bank's earnings and capital may be at risk. A non-performing loan is a loan where payments of interest or principal are overdue by 90 days or more, and it is typically presented as a percentage of outstanding loans. Net charge-offs represent the difference in loans that are written off as unlikely to be recovered (gross charge-offs) and any recoveries in previously written-off loans.
The Banking System: Federal Reserve System
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