As a follow up of our previous post on 3 Simple Banking Ratios, I wanted to share a deeper understanding of the Banking Industry and how can us value investors attempt valuing or making some sense of it. “Banks are too complicated. They are too huge. It’s not within my circle of competence.” These are some of the common responses with regards to investing in Banks. Indeed, Banks are complicated, however, they are complicated because of our actions.

History:

I believe that to understand the Banking Industry, one has to go back to the fundamentals of the banking system. The traditional banking system was to facilitate the process of making loans and funding them by issuing short-dated deposits. Essentially, this generation of revenue is termed as the 3-6-3 Rule. The 3-6-3 Rule was how the retail banks generated revenue in the United States the 1950s to 1980s. The name refers to the how bankers would pay a 3% interest on deposits, lend money out at a 6% and be able to ‘tee off at the gold course by 3pm’.

Following that, due to the repeal of the Glass-Steagall Act, the divide between Commercial Banks and Investment Banks was essentially non-existence. What was initially passed to protect the consumers after the Great Depression was repealed in the 1990s. Hence, with commercial banks engaging in more speculative activities, this resulted in the blowup in 2009; the Global Financial Crisis. In some way, I would attribute this to human greed. With the traditional banking system, it was a relatively stable and simple business of taking deposits and loaning it out, making on the interest rate differential between these two. While this was nearly a “sure win” strategy, it is also a very boring and slow business strategy. That is where trading and speculation came into play, it being a much higher margin business, which means much more risk as well.

Key Takeaway:

After understanding a brief history of the banking industry, what does it tell us? Essentially, the banks we want to be investing in would be the ones that adheres to the traditional banking system as it is something we can understand using the 3-6-3 Rule, unlike investment banks. Furthermore, the reason for the blow up during the Global Financial Crisis was due to the retail/investment banks increasing their off-balance sheet activities.

From this, we understand that we have to analyse banks from 2 viewpoints:

  • Earnings, Price-to-Earnings Ratio
  • On-Balance Sheet, Price-to-Book Ratio

Earnings:

Understanding the 3-6-3 Rule is one thing, however, we have to understand each bank’s growth strategy to be able to differentiate the ones what deals with commercial banking and the others dealing with investment banking. Such information can only be derived from reading the yearly CEO’s Statement to understand how the bank intends to run their business.

…we have never lost sight of the fundamentals of banking and have remained disciplined and measured in our growth strategy…continue to invest in our retail banking and wealth management capabilities…we have established 48 dedicated wealth management centres across the region, including a new Privilege Banking Centre in one of the most iconic buildings located on the Bund in Shanghai…

Mr. Wee Ee Chong, UOB Annual Report 2013

Using UOB as an example, such are the statements we should be looking for to conclude the growth strategy of the bank. After identifying which are the commercial banks and understanding the 3-6-3 Rule of how such commercial banks generate their earnings, the Price-to-Earnings Ratio (P/E) is an ideal metric to compare these commercial banks across the board to determine the undervalued ones.

Whilst people who practices value investing do not attempt to forecast future earnings of the company, we should still question ourselves whether we expect normalized earnings to trend upwards or downwards. This would be based on macro events and bank’s customer base.

  • Macro Events. What is the current world interest rate? Given how interest rates have been remained artificially low all this while since the Global Financial Crisis, will it continue remaining this low going forward in the next few years? In the event of an increase in interest rates, what does it mean for the bank’s earnings? Is the bank undergoing any litigations? Looking at the banking system in the United States we observe major banks facing litigation suits due to their mistakes. While litigation fees will depress bank’s earnings, it will pass eventually. Are the litigations just starting or ending soon? Investing in banks where we have some certainty of litigations passing, this depression on earnings will eventually pass as well.
  • Customer Base. Understand the business strategy of the bank. Knowing which markets the bank operates in would give a good indication of how revenue would be growing. Being located in Emerging Markets e.g. China, India etc. are ideal as we see an increase in average household income levels. One good indication that the bank is growing through their customer base would be the loan-to-deposit ratio. A consistent growth in the loan-to-deposit ratio, especially while deposits are growing, would indicate that the bank is growing from their customer base.

The reason why I believe it is crucial to form a general direction of where earnings would be trending is because such commercial banks would usually not be trading at very cheap Price-to-Earnings multiples. This is due to them being relatively safer, being regarded as blue chips and thus trading at higher multiples. Therefore, having some clue of where earnings would be trending would give us a rough estimate of whether at current multiples it may indicate an overvaluation or undervaluation.

That said, just looking at earnings is not sufficient. As mentioned previously, the balance sheet of the bank is just as important. Knowing whether the bank has quality or junk assets is crucial when investing in banks as well. The Banking Industry (Part 2) on balance sheets will be discussed in a later post.

The Banking Industry & Value Investing [Part 1]