the banking industry

7/29/2019 The Banking Industry

1/6

This article and more available at Investopedia.com

Back to Industry LiThe Industry Handbook - The Banking Industry

f there is one industry that has the stigma of being old and boring, it would have to bbanking; however, a global trend of deregulation has opened up many new businesseo 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 holdeveral billions in assets and have several subsidiaries in different industries. A perfecxample of what makes analyzing a bank stock so difficult is the length of theirnancials. The last annual report for Cisco was 50 pages, whereas Citigroup's topped-ut at 132 pages. While it would take us an entire textbook to explain all the ins and

uts of the banking industry, this guide will hopfully shed some light on the moremportant areas to look at when analyzing a bank as an investment.

There are two major types of banks in North America:

q Regional (and Thrift) Banks - These are the smaller financial institutions whoprimarily focus on one geographical area within a country. In the U.S. this isbroken up into 6 areas, Southeast, Northeast, Central, etc. Providing depositoryand lending services are regional banks primary line of business.

q Major (Mega) Banks - While these banks might maintain local branches, their

main scope is in financial centers like New York, where they get involved withinternational transactions, and underwriting, etc.

Could you imagine a world without banks? At first this might sound like a greathought! Banks (and financial institutions) have, however, for several reasons, becomornerstones of our economy. They transfer risk, provide liquidity, facilitate both majo

nd minor transactions, and provide financial information for both individuals andbusinesses.

Running a bank is just as difficult as analyzing it for investment purposes. Managemef banks must look at the following criteria before they decide how many loans toxtend, to whom the loans can be given, what rates to set, and so on:

q Capital Adequacy and the Role of Capitalq Asset & L iability Management - There is a happy medium between banks

overextending themselves (lending too much) and lending enough to make aprofit.

q Interest Rate Risk - This indicates how changes in interest rates affect

profitability.

le:///C|/Documents%20and%20Settings/VLobo/Desktop/...e%20Industry%20Handbook/The%20Banking%20Industry.htm (1 of 6)7/18/2005 3:34:39 PM
http://www.investopedia.com/features/industryhandbook/http://www.investopedia.com/terms/u/underwriting.asphttp://www.investopedia.com/terms/l/liquidity.asphttp://www.investopedia.com/terms/i/interestrate.asphttp://www.investopedia.com/terms/i/interestrate.asphttp://www.investopedia.com/terms/l/liquidity.asphttp://www.investopedia.com/terms/u/underwriting.asphttp://www.investopedia.com/features/industryhandbook/http://www.investopedia.com/


2/6


q Liquidity - This is formulated as the proportion of outstanding loans to totalassets. If more than 60-70% of total assets are loaned out, the bank isconsidered to be highly illiquid.

q Asset Quality - What is the likelihood ofdefault?

q Profitability - This is earnings and revenue growth.

Perhaps the banking industry's largest distinction is the government's heavy

nvolvement in it. Besides setting restrictions on borrowing limits and the amount ofeposits that the bank must hold in their vault, the government (mainly the Federal

Reserve) has a huge influence on a banks profitability.

Key Players

Although there are many large banks, the top three in the world are:

q Mizuho Holdings, Inc. - A Japanese based bank, the first bank to reach $1trillion dollars in assets.

q Citigroup - They operate several subsidiaries including Citibank and brokeragegiant, Salomon Smith Barney.

q Deutsche Bank - Formerly the world's largest bank, Deutsche Bank has largeoperations in Europe and Asia, as well as in the States.

Key Ratios/Terms

nterest Rates In the United States, the Federal Reserve decides theinterest rates. Because interest rates directly affect the

credit market (loans), banks constantly try to predict thenext interest rate moves, so they can adjust their ownrates. A bad prediction on the movement of interest ratescan cost millions.

Gap This refers to the difference, over time, between the asseand liabilities of a financial institution. A "negative gap"occurs when liabilities are higher than assets. Converselywhen there are more assets than liabilities, there is apositive gap. When interest rates are going up, banks wit

a positive gap will profit. The opposite is true when intererates are falling.

http://www.investopedia.com/terms/d/default2.asphttp://www.investopedia.com/university/thefed/http://www.investopedia.com/university/thefed/http://www.investopedia.com/university/thefed/http://www.investopedia.com/university/thefed/http://www.investopedia.com/terms/d/default2.asp


3/6


Capital Adequacy A bank's capital, or equity, is the margin by which credito

are covered if the bank had to liquidate assets. A goodmeasure of a bank's health is its capital/asset ratio, whichby law, is required to be above a prescribed minimum.

The following are the current minimum capital adequacyratios:

q Tier one capital to total risk weighted credit (seebelow) must not be less than 4%.

q Total capital (tier one plus tier two less certaindeductions) to total risk weighted credit exposuresmust not be less than 8%.

The risk weighting is prescribed by the Bank ofInternational Settlements. For example, cash andgovernment securities is said to have zero risk, whereas

mortgages have a risk weight of 0.5. Multiplying the asseby their risk weight makes the total risk-weighted assets,which is then used to determine the capital adequacy. Ifyou want to learn more on calculating this ratio click here

Tier 1 Capital In relation to the capital adequacy ratio, tier one capitalcan absorb losses without a bank being required to ceasetrading. This is core capital, and includes equity capital andisclosed reserves.

Tier 2 Capital In relation to the capital adequacy ratio, tier two capital cabsorb losses in the event of a winding-up, and so provida lesser degree of protection to depositors. It includesitems such as undisclosed reserves, general loss reservesand subordinated term debt.

Gross Yield on EarningAssets (GYEA) =

Total Interest Income

Total Earning Assets

This tells you what yields were generated from invested

capital (assets).

Rates Paid on FundsRPF) =

Total Interest Expense


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

http://www.investopedia.com/terms/c/creditor.asphttp://www.investopedia.com/offsite.asp?URL=http://wfhummel.cnchost.com/capitalrequirements.htmlhttp://www.investopedia.com/offsite.asp?URL=http://wfhummel.cnchost.com/capitalrequirements.htmlhttp://www.investopedia.com/terms/c/creditor.asp


4/6


Net Interest MarginNIM) =

(Total Interest Income -Total Interest Expense)


This tells you the average interest margin that the bank isreceiving by borrowing and lending funds.

Analyst Insight

nterest rate fluctuations play a huge role in the profitability of a bank. Banks are,herefore, trying to get away from this dependency by generating more revenue on fe

based services. Many bank financial statements will break up the revenue figures intoee-based (or non interest) and non-fee (interest) generated revenue. Make sure youake a close look at the fee based revenue: firms with a higher fee-based revenue wilypically earn a higher return on assets than competitors.

Evaluating management can be difficult because so many aspects of the job are

ntangible. One key figure for evaluating management is the Net Interest Margindefined above). Look at the past NIM across several years to determine its trends.deally you want to see an even or upward trend. Most banks will have NIMs in the 2-% 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

% ROA indicates huge profits. This is one area that catches a lot of investors:echnology companies might have an ROA of 5% or more, but these figures cannot be

irectly compared to banks.As with other industries, you want to know that a bank has costs under control, andhat things are being run efficiently. Analyze closely the operating expenses of the

bank. Ideally, you want to see operating expenses flat or lower than previous years.This isn't to say that an increase in operating expenses is a bad thing, as long asevenues are also increasing.

As we mentioned in the above section, a measure of a bank's financial health is itsapital adequacy. If a bank is having difficulty meeting the capital ratio requirements,

an use a number of ways to increase the ratio. If it is publicly traded, it can issue netock or sell more subordinated debt. That, however, may be costly if the bank is in a

weak financial position. Small banks, since most are not publicly traded, generally doot have the option of selling new stock. If the bank cannot increase its equity, it caneduce its assets to improve the capital ratio. Shrinking the balance sheet, however, iot attractive because it hurts profitability. The last option is to seek a merger with atronger bank.

Porter's 5 Forces Analysis (Learn More)

http://www.investopedia.com/terms/r/returnonassets.asphttp://www.investopedia.com/terms/r/returnonassets.asphttp://www.investopedia.com/terms/s/subordinateddebt.asphttp://www.investopedia.com/features/industryhandbook/porter.asphttp://www.investopedia.com/features/industryhandbook/porter.asphttp://www.investopedia.com/terms/s/subordinateddebt.asphttp://www.investopedia.com/terms/r/returnonassets.asphttp://www.investopedia.com/terms/r/returnonassets.asp


5/6


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 whichentrepreneurs can capitalize. Banks are fearful of being squeezed out of thepayments business, especially since it is a good source of fee-based revenue.Another trend that poses a threat is companies offering other financial servicesWhat would it take for an insurance company to start offering mortgage and loaservice? Not much. Also, when analyzing a regional bank, remember that the

threat of a 'mega bank' entering into the market poses a real threat.

2. Pow er of Suppliers (?) - The suppliers of capital might not pose a big threat,

but the threat of suppliers luring away human capital does. If a talentedindividual is working in a smaller regional bank, there is the chance that thatperson will be enticed away by bigger banks, investment firms, etc.

3. Pow er 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 relativehigh switching costs. If a person has their mortgage, car loan, credit card,

checking account, and mutual funds with one particular bank, it can make itextremely tough for them to switch. In an attempt to lure-in customers, bankstry to lower the price of switching, but many people would still rather stick withtheir current bank. On the other hand, large corporate clients have bankswrapped around their little finger. Financial institutions--by offering betterexchange rates, more services, and exposure to foreign capital markets--tryextremely hard to get high margin corporate clients.

4. Availabili ty of Substitutes (?) - As you can probably imagine, there are plen

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, mutualfunds, or fixed income securities, chances are there is a non-banking financialservices company who can offer similar services. In the lending side of thebusiness, banks are seeing competition rise from unconventional companies.Sony, General Motors, and Microsoft all offer preferred financing to customerswho buy big ticket items. If car companies are offering 0% financing, why woulanyone 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 abo

everyone who needs banking services already has them. Because of this, banksmust attempt to lure clients away from competitor banks. They do this byoffering lower financing, preferred rates, and investment services. The bankingsector is in a race to see who can offer the better and faster services, but thisalso causes banks to experience a lower ROA. They then have an incentive totake- on high risk projects. In the long run, we're likely to see more consolidatiin the banking industry. Larger banks would prefer to takeover or merge withanother bank rather than spend the money to market and advertise to people.

http://www.investopedia.com/features/industryhandbook/porter.asphttp://www.investopedia.com/features/industryhandbook/porter.asphttp://www.investopedia.com/features/industryhandbook/porter.asphttp://www.investopedia.com/features/industryhandbook/porter.asphttp://www.investopedia.com/features/industryhandbook/porter.asphttp://www.investopedia.com/features/industryhandbook/porter.asphttp://www.investopedia.com/features/industryhandbook/porter.asphttp://www.investopedia.com/features/industryhandbook/porter.asphttp://www.investopedia.com/features/industryhandbook/porter.asphttp://www.investopedia.com/features/industryhandbook/porter.asp


6/6


Key Links

q American Bankers Association - Get the latest industry facts and regulatory

developments.q American Banker - Get resources and news on all aspects of the banking

industry.q Federal Reserve - The official site of the US Federal Reserve, here you can lea

about the monetary system, read papers, and get the latest statistical data.

** This article and more are available at Investopedia.com - Your Source for InvestingEducation **

l ///C|/D t %20 d%20S tti /VL b /D kt / %20I d t %20H db k/Th %20B ki %20I d t ht (6 f 6)7/18/2005 3 34 39 PM
http://www.investopedia.com/offsite.asp?URL=http://www.aba.comhttp://www.americanbanker.com/index.htmlhttp://www.investopedia.com/offsite.asp?URL=http://www.federalreserve.govhttp://www.investopedia.com/offsite.asp?URL=http://www.federalreserve.govhttp://www.americanbanker.com/index.htmlhttp://www.investopedia.com/offsite.asp?URL=http://www.aba.com