The Banking Industry (Part 2)

After touching on the earnings part in (Part 1), I will be touching on the balance sheet of banks in this article.

What lead to the blowup in 2009? Banks were selling Asset-Backed Securities (ABS) pre-crisis to improve their capital ratio by the definition of Basel II. What does this mean? Banks were making risky loans to lousy credit rating borrowers and then repackaging these risky loans with good loans and selling it as a financial product. With the mixture of the good loans in it, it resulted in a above average rating on the financial product, which resulted in why it was able to be sold. Hence, the banks did this to raise additional cash and loaned it out again. This cycle kept repeating itself for the banks to increase their capital ratio to normal levels.

Given how these bank’s seems to be one huge “black box”, how then can we assess the quality of the bank’s assets?

One key point would be the international regulatory framework set by the Basel Committee that banks have to adhere to. While I will not go into the details of how the capital ratio is being calculated, essentially banks that follow this system have to report their capital ratio in the annual reports. While banks have certain requirements to meet under the latest Basel III requirements, I believe that an ideal capital ratio for both Common Equity Tier 1 and Tier 1 Capital to be above 10%, well above the minimum requirements set.

Yet, some may question, “With banks selling ABS to increase their capital ratios, it can mean banks fulfilling the capital ratio but still having lousy assets.”

To answer that question, “Yes, it is very true.” This is why, on top of the capital ratios, we would have to observe the Return on Equity (ROE) and Return on Assets (ROA) figures. These two returns have to be used concurrently, solely because a company can be achieving very high ROE and low ROA figures due to high leveraging. Therefore, these two metrics have to be used concurrently. Banks that have a huge difference between ROE and ROA figures would mean that a larger portion of their returns are derived from leverage instead of their assets.

With these two checks: (1) Capital Ratio and (2) ROE & ROA figures, we would be able to determine the quality of the bank’s assets. Hence, to best value the bank in this scenario, we would use the Price-to-Book (P/B) to compare the valuations of the banks.

To conclude, I hope that with this write-up on The Banking Industry, one would gain a better understanding of the banking industry, especially in terms of valuations. That said, I would caution investors when investing in banks as they are a whole different creature. This is why if one truly understands Graham’s Principles, a majority of our portfolio would be made up of brick and mortar companies. With banks, perhaps only investing in them at the at of a credit crunch cycle alongside with the FED’s fiscal policy would be the ideal moment. Furthermore using Wells Fargo as a form of benchmark would be a wise choice as well.

The Banking Industry & Value Investing [Part 2]