The Industry Handbook: The Banking Industry

If there is one industry that has the stigma of being old and boring, it would have to be banking; however, a global trend of deregulation has opened up many new businesses to the banks. Coupling that with technological developments like internet banking and ATMs, the banking industry is obviously trying its hardest to shed its lackluster image.

There is no question that bank stocks are among the hardest to analyze. Many banks hold billions of dollars in assets and have several subsidiaries in different industries. A perfect example of what makes analyzing a bank stock so difficult is the length of their financials - they are typically well over 100 pages. While it would take an entire textbook to explain all the ins and outs of the banking industry, here we'll shed some light on the more important areas to look at when analyzing a bank as an investment. (For background reading, see Analyzing A Bank's Financial Statements.)

There are two major types of banks in North America:

• Regional (and Thrift) Banks - These are the smaller financial institutions, which primarily focus on one geographical area within a country. In the U.S., there are six regions: Southeast, Northeast, Central, etc. Providing depository and lending services is the primary line of business for regional banks.
• Major (Mega) Banks - While these banks might maintain local branches, their main scope is in financial centers like New York, where they get involved with international transactions and underwriting.

Could you imagine a world without banks? At first, this might sound like a great thought! But banks (and financial institutions) have become cornerstones of our economy for several reasons. They transfer risk, provide liquidity, facilitate both major and minor transactions and provide financial information for both individuals and businesses.

Running a bank is just as difficult as analyzing it for investment purposes. A bank's management must look at the following criteria before it decides how many loans to extend, to whom the loans can be given, what rates to set, and so on:

• Capital Adequacy and the Role of Capital
• Asset and Liability Management - There is a happy medium between banks overextending themselves (lending too much) and lending enough to make a profit.
• Interest Rate Risk - This indicates how changes in interest rates affect profitability.
• Liquidity - This is formulated as the proportion of outstanding loans to total assets. If more than 60-70% of total assets are loaned out, the bank is considered to be highly illiquid.
• Asset Quality - What is the likelihood of default?
• Profitability - This is earnings and revenue growth.

Perhaps the biggest distinction that sets the banking industry apart from others is the government's heavy involvement in it. Besides setting restrictions on borrowing limits and the amount of deposits that a bank must hold in the vault, the government (mainly the Federal Reserve) has a huge influence on a bank's profitability. (To learn more about the Fed, read the Federal Reserve Tutorial.)

Key Ratios/Terms

Interest Rates: In the U.S., the Federal Reserve decides the interest rates. Because interest rates directly affect the credit market (loans), banks constantly try to predict the next interest rate moves, so they can adjust their own rates. A bad prediction on the movement of interest rates can cost millions. (To learn more, read Trying To Predict Interest Rates.)

Gap: This refers to the difference, over time, between the assets and liabilities of a financial institution. A "negative gap" occurs when liabilities are higher than assets. Conversely, when there are more assets than liabilities, there is a positive gap. When interest rates are going up, banks with a positive gap will profit. The opposite is true when interest rates are falling.

Capital Adequacy: A bank's capital, or equity, is the margin by which creditors are covered if the bank has to liquidate assets. A good measure of a bank's health is its capital/asset ratio, which, by law, is required to be above a prescribed minimum.

The following are the current minimum capital adequacy ratios:

• Tier 1 capital to total risk weighted credit (see below) must not be less than 4%.
• Total capital (Tier 1 plus Tier 2 less certain deductions) to total risk weighted credit exposures must not be less than 8%. (For more on this, read How Do Banks Determine Risk?)

The risk weighting is prescribed by the Bank for International Settlements. For example, cash and government securities are said to have zero risk, whereas mortgages have a risk weight of 0.5. Multiplying the assets by their risk weights gives the total risk-weighted assets, which is then used to determine the capital adequacy.

Tier 1 Capital: In relation to the capital adequacy ratio, Tier 1 capital can absorb losses without a bank being required to cease trading. This is core capital, and includes equity capital and disclosed reserves.

Tier 2 Capital: In relation to the capital adequacy ratio, Tier 2 capital can absorb losses in the event of a winding up, so it provides less protection to depositors. It includes items such as undisclosed reserves, general loss reserves and subordinated term debt.

Gross Yield on Earning Assets (GYEA) = Total Interest Income
Total Earning Assets

This tells you what yields were generated from invested capital (assets).

Rates Paid on Funds (RPF) = Total Interest Expense
Total Earning Assets

This tells you the average interest rate that the bank is paying on borrowed funds.

Net Interest Margin (NIM) = (Total Interest Income - Total Interest Expense)
Total Earning Assets

This tells you the average interest margin that the bank is receiving by borrowing and lending funds

Analyst Insight
Interest rate fluctuations play a huge role in the profitability of a bank. Banks are, therefore, trying to get away from this dependency by generating more revenue on fee-based services. Many bank financial statements will break up the revenue figures into fee-based (or non interest) and non-fee (interest) generated revenue. Make sure you take a close look at the fee-based revenue: firms with a higher fee-based revenue will typically earn a higher return on assets than competitors.

Evaluating management can be difficult because so many aspects of the job are intangible. One key figure for evaluating management is the net interest margin (NIM) (defined above). Look at the past NIM across several years to determine its trends. Ideally, you want to see an even or upward trend. Most banks will have NIMs in the 2-5% range; this might appear low, but don't be fooled - a .01% change from the previous year means big changes in profits.

Another good metric for evaluating management performance is a bank's return on assets (ROA). When calculating ROA, remember that banks are highly leveraged, so a 1% ROA indicates huge profits. This is one area that catches a lot of investors: technology companies might have an ROA of 5% or more, but these figures cannot be directly compared to banks. (To learn more, read ROA On The Way.)

As with other industries, you want to know that a bank has costs under control, and that things are being run efficiently. Closely analyze the bank's operating expenses. Ideally, you want to see operating expenses remain the same as previous years or to decrease. This isn't to say that an increase in operating expenses is a bad thing, as long as revenues are also increasing.

As we mentioned in the above section, a measure of a bank's financial health is its capital adequacy. If a bank is having difficulty meeting the capital ratio requirements, it can use a number of ways to increase the ratio. If it is publicly traded, it can issue new stock or sell more subordinated debt. That, however, may be costly if the bank is in a weak financial position. Small banks, most of which are not publicly traded, generally do not have the option of selling new stock. If the bank cannot increase its equity, it can reduce its assets to improve the capital ratio. Shrinking the balance sheet, however, is not attractive because it hurts profitability. The last option is to seek a merger with a stronger bank.


Porter's 5 Forces Analysis

1. Threat of New Entrants. The average person can't come along and start up a bank, but there are services, such as internet bill payment, on which entrepreneurs can capitalize. Banks are fearful of being squeezed out of the payments business, because it is a good source of fee-based revenue. Another trend that poses a threat is companies offering other financial services. What would it take for an insurance company to start offering mortgage and loan services? Not much. Also, when analyzing a regional bank, remember that the possibility of a mega bank entering into the market poses a real threat.
   
2. Power of Suppliers. The suppliers of capital might not pose a big threat, but the threat of suppliers luring away human capital does. If a talented individual is working in a smaller regional bank, there is the chance that person will be enticed away by bigger banks, investment firms, etc.
   
3. Power of Buyers. The individual doesn't pose much of a threat to the banking industry, but one major factor affecting the power of buyers is relatively high switching costs. If a person has a mortgage, car loan, credit card, checking account and mutual funds with one particular bank, it can be extremely tough for that person to switch to another bank. In an attempt to lure in customers, banks try to lower the price of switching, but many people would still rather stick with their current bank. On the other hand, large corporate clients have banks wrapped around their little fingers. Financial institutions - by offering better exchange rates, more services, and exposure to foreign capital markets - work extremely hard to get high-margin corporate clients.
   
4. Availability of Substitutes. As you can probably imagine, there are plenty of substitutes in the banking industry. Banks offer a suite of services over and above taking deposits and lending money, but whether it is insurance, mutual funds or fixed income securities, chances are there is a non-banking financial services company that can offer similar services. On the lending side of the business, banks are seeing competition rise from unconventional companies. Sony (NYSE: SNE), General Motors (NYSE:GM) and Microsoft (Nasdaq:MSFT) all offer preferred financing to customers who buy big ticket items. If car companies are offering 0% financing, why would anyone want to get a car loan from the bank and pay 5-10% interest?
   
5. Competitive Rivalry. The banking industry is highly competitive. The financial services industry has been around for hundreds of years, and just about everyone who needs banking services already has them. Because of this, banks must attempt to lure clients away from competitor banks. They do this by offering lower financing, preferred rates and investment services. The banking sector is in a race to see who can offer both the best and fastest services, but this also causes banks to experience a lower ROA. They then have an incentive to take on high-risk projects. In the long run, we're likely to see more consolidation in the banking industry. Larger banks would prefer to take over or merge with another bank rather than spend the money to market and advertise to people.

Key Links

• American Bankers Association - Get the latest industry facts and regulatory developments
• American Banker - Get resources and news on all aspects of the banking industry
• Federal Reserve - The official site of the U.S. Federal Reserve. Here you can learn about the monetary system, read papers and get the latest statistical data.

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