The Banking Sector: The Red Flags 🚩🚩🚩

 

As I’ve mentioned before, banks are notoriously tough to value. But an investor must not feel daunted by this. This should be a good opportunity to make gains where others find them hard to see.

As part of this effort, one should have a good understanding of what key metrics mean and the red flags that can pop out of evaluating them.

What to look at

Many analysts place importance on absolute values of certain metrics. For instance, investors have for a long time believed that a PEG ratio of 1 equals fair value. Or a PEG ratio of greater than 1 means lower potential returns.

However, it is very difficult to objectively assess a range for a metric which would make a company cheap or expensive. This is why a metric for any company has to be compared relative to the average (mean or median) of the metric in the sector as a whole. This is the method I use.

The median should be the benchmark if there are plenty of outliers in the data. But the benchmark could be the mean if there are little to no outliers or if there are significant outliers, they are excluded from the data.

Return of Assets (ROA)

ROA is an important metric for all sectors but perhaps even more so for banks. This is simply because banks earn directly from their assets (loans).

A higher ROA indicates better profitability and more efficient use of assets. So, one must look for banks with a ROA higher than the average. Standard practice in the banking sector is to use ROE as a judge of profitability which I believe is incorrect.

ROE is a poor measure of profitability because a bank can have a large ROE if it is highly leveraged. This means that a bank with a high ROE could carry huge risks with it too. Secondly, ROE is hugely influenced by book value which is a poor metric for valuing banks.

Book value is simply the accounting way of measuring equity. Banks generally invest in human capital to generate high returns on lending and brand image to attract deposits. Book value takes no aim at measuring either of these or the value they generate. It also must be noted that book value can be written down and it can easily be distorted by accounting measures like ‘goodwill’. In fact, book value is a measure of liquidation value for debt investors, so not very relevant for equity investors who are more interested in the returns a company can generate from its assets.  

Interest spread

In the previous blog I mentioned: the interest spread for a bank is the difference between its cost of deposits and lending rate. One fact to notice is that most banks would have very similar lending rates due to competition or in the Pakistani context, due to regulations on conventional banking. So, within the interest spread, the key metric of focus is actually cost of deposits.

How do banks lower the cost of deposits? By maintaining a higher number of current accounts (pay no interest) as opposed to savings account (which pay interest) for depositors. This can be a significant competitive advantage for banks, especially as they become larger. So, look for banks which have an above average interest spread (or below average cost of deposits).

A very high cost of deposit will be a red flag which needs further investigation by a look-through at how the bank is then investing those deposits. Will the bank sustainably generate high lending rates in the future?

Percentage of securities held-to-maturity

In bank accounting, securities can be marked-to-market (usually mentioned as ‘available-for-sale’ [AFS] or ‘held-for-trading’ [HFT] in financial statements) or flagged as held-to-maturity.

The difference is that under marked-to-market, securities are valued at their current market values which translates into unrealized losses on the income statement. In comparison, under held-to-maturity, securities are marked at their original value as opposed to market or fair value. This means that unrealized losses from held-to-maturity securities do not translate into unrealized losses in earnings.

This slight difference in accounting can be very consequential. Banks should have almost all securities under marked-to-market. Why? Because it gives an accurate picture of a bank’s investments.

Let’s say depositors withdraw their deposits greater than the bank expected – leading to a depletion of reserves for this purpose. Now, the bank would have to fund additional deposit withdrawals by selling their assets. They can’t sell loans so they would be forced to sell their securities. If securities are marked-to-market, the losses on them have already been realized so it’s not an issue. However, if the securities are held-to-maturity securities, they will have to be sold realizing the losses in the next financial report. So, held-to-maturity can be manipulated by banks to underreport their true losses especially in a rising interest rate environment.

Consequently, one should look for a bank with a below-average percentage of securities held-to-maturity. If the bank fails this check, it can also be indicative of poor management which is cooking the books to hide other losses – a common occurrence with banks.

Tier 1 Capital Ratio

Tier 1 capital ratio is certainly the most important metric for banks as it indicates the capitalization of a bank. But first, what comes under tier 1 capital? Or rather, how is capital defined for banks?

Capital is divided into tier 1 and tier 2 capital. Tier 1 capital includes disclosed reserves (retained earnings) and shareholder’s equity. While tier 2 capital includes non-deposit debt, hybrid capital (callable bonds), undisclosed reserves as well as other kinds of reserves (revalued reserves). Tier 1 capital is more important as it is far more liquid, can be measured more accurately and can readily absorb losses as they come.

Now, capital ratios are calculated by dividing the capital by risk weighted (adjusted) assets. Risk weighted assets are calculated by assigning a risk weight to each asset the bank has and summing up the multiples of the weight and asset. For instance, if a bank has $1,000 of loans with 50% risk and $1,000 of government bonds (risk-free), the risk adjusted assets would be $500.

Basel III regulations dictate that tier 1 capital ratio must be at least 10.5%. Besides this regulatory importance, the tier 1 capital ratio can reveal the risk appetite of the bank.

One should look for an above-average tier 1 capital ratio as it would mean the bank has lower risk. Well-capitalized banks generally have a tier 1 capital ratio of 15% or above. This cushion above the regulatory requirement is essential to absorb unexpected losses and stay clear of any future regulatory troubles or sanctions.

Basel III regulation also has minimum requirements for two other capital ratios (common equity tier 1 capital and total capital), but tier 1 capital ratio is the gold standard due to its liquidity and accuracy in measurement.

How does this all come together?

The difficulties in valuing banks means that analysts have to rely on certain metrics. Although there is a plethora of metrics out there, I decided to focus on the four most important ones.

Look for banks which after well-capitalized through tier 1 capital ratio, are transparent in their financial reporting (low % of securities in HTM), have a high interest spread and a high ROE relative to the sector averages. Besides these metrics, a high dividend yield would be a cherry on the top.