Benchmarking is an important tool in the financial world. Companies, hedge funds, mutual funds, investors, and other financial bodies pick a specific benchmark in the industry and seek to replicate its returns or to compare its own performance to that of the benchmark. Of course, the company's business plan or investing strategy has to be the same or similar to that of the benchmark to make it a worthwhile comparison.

Companies and banks typically use ratios as benchmarks, such as liquidity ratios and debt ratios, as opposed to investment firms that typically use market index benchmarks, such as the S&P 500. There are of course exceptions to every scenario.

The appropriate benchmarks for tracking the banking sector's performance depend on the type of bank. For instance, commercial-only banks are evaluated very differently than retail-only banks. For smaller savings and loan institutions, standard benchmarks include net interest margins, the ratio between equity and total assets, and accounts receivable collection ratios. Huge multinational firms, on the other hand, should be tracked with profitability ratios, average net asset values, and market indexes designed to track the overall performance of one sector.

Other benchmarks can be more specifically selected through exchange traded funds (ETFs) or mutual funds. Many sectors have their own ETFs that track the performance of companies as an aggregate in that sector. For example, the financial sector can be tracked by the iShares U.S. Financial Services ETF (IYG) and the Vanguard Financials Index ETF (VFH). These ETFs contain some of the largest U.S. banks, such as Wells Fargo, Citigroup, Bank of America, and JP Morgan Chase.

It's important to take a look at what companies are included in these ETFs as they often contain companies outside of the banking specific sector but that fit in the overall financial sector. For example, both these ETFs include credit card companies.

Sector Benchmarking

The term "benchmark" is thrown around a lot in financial literature, but it doesn't always mean the same thing in every possible situation. In corporate governance and business consulting, for instance, benchmarking is the process by which one company tracks the performance of and tries to emulate another company, often a leading competitor. Management might establish reaching these benchmarks as goals within the context of a long-term financial strategy for the company.

Sector benchmarking is different. Investors and analysts look to sector benchmarks as a reference point. They can compare the performance of their portfolios or a specific stock against the generalized performance of an entire sector. In terms of banking sector benchmarking, this means tracking market indexes tied to the financial services sector. Industries such as banking, insurance, and others are likely to be included.

A banking sector index is designed to track the stock market performance of major banking companies. The Dow Jones has specific sub-indexes, such as the U.S. Financials Index, based on companies with large market capitalizations that are traded on the New York Stock Exchange. The example of the two ETFs, IYG and VFH, would be an example of sector benchmarking as well. It's a way to compare apples and apples when looking at one's own portfolio versus the specific segment of the market.

Fundamentals of Banking

Banks are not all homogeneous, so each fundamental metric reflects better on some firms over others. Most banks are concerned with their net interest margins, which looks at the interest earned on loaning out money versus interest paid out on customer deposits. Other important ratios to use as benchmarks include return on assets, provisions for credit losses, and return on equity. One of the most important benchmarks to review when comparing banks are solvency ratios. This helps determine how liquid a bank is and if they have the funds available to meet their long-term obligations and pay back customer deposits.

There are many other ratios that investors can use as benchmarks when tracking the performance of a bank. In general, a sector is likely to correlate more consistently with broad economic performance than individual firms do. Investors should also keep an eye on interest rate policy, Federal Reserve action, and the value of high-priced assets, as these impact the performance of individual firms.

The Bottom Line

There are many different approaches to benchmarking the banking sector. Using ratios to compare one company to another is extremely helpful in gauging the financial health of that company and how it is performing when compared to its peers. A market index, often accessed through exchange traded funds, is another type of benchmark that can be used to compare companies with the performance of the sector as a whole. Either way, it's important to ensure that what you are comparing is similar in shared characteristics to make sure that your analysis is accurate.