Overview
When you think of a bank, what thoughts come to mind?
For most people, this usually evokes images of an institution that stores their money and manages their day-to-day transactions. When people get paid or businesses receive payments from customers, the funds usually find their way into a bank account. When a person or business needs to buy something, then the funds usually originate from a bank.
In addition to storing money, there are those who see banks as institutions that extend credit to them to help make certain transactions possible. Whether it’s a mortgage to help with the purchase of a house or a business loan to aid in the purchase of new factory equipment, banks extend all sorts of loans to all sorts of people and institutions.
If this is how banks are viewed through the eyes of their customers and members of the public, then how are they seen from an investor’s point of view?
When thinking of “hot” investment prospects, banks don’t usually come to mind. Investors with long memories may view banks in a negative light because of the role they played in the 2008-2009 Global Financial Crisis, and how the global financial system was on the brink of collapse because of a handful of greedy banks.
However, there are many investors who view bank equities as a central part of their portfolio and overall investment strategy – but why? This article will help shed some light on that.
Becoming Familiar With the Different Types of Banks
Depending on the types of clients they wish to serve, there exist various types of banks. For the sake of simplicity, we will go over the ones you most likely have heard of before and/or will have dealings with.
By far the most common type is a retail bank. Their services are targeted toward individuals who wish to keep their money somewhere, have access to credit, and offer other related financial services such as insurance.
Closely related to retail banks are commercial banks. Commercial banks offer similar services such as maintaining deposits and extending credit, but their customer base is tailored for institutions such as businesses, NGOs, and government agencies.
Credit unions are a special kind of financial institution. Although they offer many of the services a typical bank does, the key difference is that they are member-owned and non-profit.
Traditional banks are usually for-profit corporations, meaning they are owned by shareholders and operate with the explicit purpose of making money (i.e., they have retained earnings). Credit unions, on the other hand, are owned by their members and make just enough money to pay the staff that run them, as well as to pay other related business expenses.
Unlike the aforementioned banks, investment banks are entirely different entities. Instead of taking deposits and offering loans, investment banks serve to help their clients raise capital by assisting them with their equity or debt offerings. For example, if a company decides to become publicly listed in the near future by offering shares of stock, then investment banks are there to help them with that. Investment banks are also known to assist in mergers and acquisitions (M&A) and related financial market services.
It’s common for large financial institutions (in terms of the capital they have and the size of their workforce) to offer several banking services. For example, the Royal Bank of Canada (RBC) offers retail, commercial, and investment banking services, among its suite of other financial services.
From this point onwards, for the sake of simplicity the terms “bank(s)”
and “financial institution(s)” will be used interchangeably.
The Banking Business Model – A Unifying Factor
With the exception of investment banks, at their core, banks offer two fundamental services: serving as a place for clients to store their money and offering their clients credit. Depositing your money at a bank seems simple enough, but what funds do they use to offer loans?
Some bank accounts, in particular savings accounts, pay interest on the balance, usually on a monthly basis. But why would a bank pay you simply for keeping your money with them – shouldn’t it be the other way around?
That’s because when you deposit your money into a bank, you are essentially loaning your money to them. From a strictly business perspective, nobody loans money for free, which is why you earn interest from certain accounts.
In turn, banks use these deposited funds to finance the loans which they extend to their own clients. Because deposits are essentially just loans they receive from clients and can be demanded from clients at a moment’s notice when they withdraw funds, they show up as liabilities on a bank’s balance sheet.
Of all the deposits that a bank receives, some of the funds are used to finance their loans, while some funds are kept for when clients want to make withdrawals – this forms a bank’s “reserves”. This system of allocating some deposits to offer loans and some to maintain reserves is known as “fractional reserve banking”.
When looking at the income statement of a bank, their revenue is split into two categories: interest and non-interest income. You’ll probably then notice that interest income makes up the bulk of total revenue and that this interest is primarily earned from the loans they extend to clients.
Banks, first and foremost, are loan-granting institutions, and the revenue they generate comes primarily from the interest they charge on their loans.
In addition to extending credit, banks also use the funds they get from deposits to purchase marketable securities, such as equities and fixed-income instruments. These securities provide banks with another source of income, whether it’s from interest payments or dividend distributions.
Some banks turn into more generalized financial institutions that offer a variety of services to diversify their revenue streams. However, if they continue to maintain large deposits, then they can continue to offer an abundance of loans, meaning they can still earn a sizeable portion of their revenue from the interest they charge.
Again, the exception to this is investment banks: instead of relying on interest earned from loans, they instead earn their revenue primarily from the large fees they charge their clients. Investment banks still extend credit to clients, just not to the same degree as retail/commercial banks do.
Which Investment Factors to Focus on When Looking at Banks
Bank equities serve an integral role in many portfolios, and part of that is due to a bank’s relatively simple yet robust business model. Because of this, many investors turn to bank equities as a source of steady returns and consistent dividends.
Although banks are relatively simple to understand, this doesn’t mean investors can take it easy when analyzing their investment merit. There are a number of factors that investors may want to pay attention to when looking at prospective banks they want to add to their portfolios.
Loans Extended and Deposits Made
Earlier we talked about how, with the exception of investment banks, banks serve primarily as loan-granting institutions, which they finance by using the deposited funds of their clients. Banks pay interest on deposited funds and charge interest on the loans they extend: the difference between these two is what they keep as revenue.
One of the easiest metrics that investors can check for overall business health is the value of all outstanding loans and the value of all current deposits. Fortunately, these figures can easily be found on the balance sheet: loans are listed under “assets”, and deposits are listed under “liabilities”.
Ideally, both loans and deposits should increase over time: an increase in deposits means banks have more funds they can use to extend loans, meaning more interest income they potentially stand to collect.
Typically, the total value of all loans a bank currently has is less than their deposits. For example, a bank may currently have $600 billion worth of loans, but $800 billion in deposits. This observation makes perfect sense; as was mentioned earlier, most banks run on a fractional reserve system, so they need to keep sufficient funds on hand in case clients want to make withdrawals.
Loan and deposit values fluctuate over time, which for the most part is normal and should be expected. However, investors will want to focus their attention on long-term trends: if loans and deposits are gradually increasing over time, then that’s good, if instead they’re declining, then investors will want to start understanding why and determine if this downward trend will likely continue.
Understanding the Loan Profile
Knowing how a bank’s loan and deposit totals change over time is important to know, but this information doesn’t offer much insight, if any, as to why these values fluctuate the way they do. There are many factors that may contribute to those fluctuations, however, this doesn’t mean they can’t be explained at all.
Most, if not all, banks release a detailed breakdown of all their outstanding loans. Banks can decide how they present this information, but they more or less follow the same formatting. Assuming a bank has both retail and commercial operations, its loans will usually fall under one of these two major categories.
Within these categories, loans will usually be further subdivided, such as specific retail loans (mortgages, personal loans, credit cards, etc.), or in the case of commercial loans, specific industries/sectors. The value of all their outstanding loans that fall under a certain specification is then displayed.
In addition to a breakdown of all outstanding loans, this information is usually supplemented by an equally detailed breakdown of all impaired loans. Impaired loans are ones that have deteriorated in quality to the point that a bank is no longer confident that the principal and interest can be collected on time.
Just as all outstanding loans are categorized based on a bank’s preferences, so too are its impaired loans.
By taking the time to understand a bank’s loan profile, investors can better understand where exactly a bank’s loans end up and better understand why exactly a bank’s outstanding loan balances fluctuate the way they do.
For example, if a handful of industries make up the bulk of a bank’s commercial loans, yet impairments have gradually been increasing in recent years, then investors should keep an eye on what a bank will do to address these losses. If no action is being taken, and interest income starts to drop as a result, then perhaps it’s time for an investor to sell their stake in that bank.
Efficiency Ratio
As was mentioned earlier, when looking at banks, their “total revenue” is usually split into two categories: net interest income and non-interest income.
Net interest income, as the name suggests, is gross interest income less total interest expenses. On the other hand, non-interest income is any money earned from other business activities, such as insurance premiums, investment services, and underwriting fees.
A bank’s expenses can also be split into one of two categories: interest and non-interest expenses. Interest expenses are the interest payments that banks pay on client deposits and other liabilities, while non-interest expenses deal with all other expenditures, such as salaries and the upkeep of equipment.
Knowing how a bank’s revenue and expenses change over time is important, but how exactly do these figures relate to one another?
Amongst the many metrics that banks commonly report, there is one known as the “efficiency ratio”. Expressed as a percentage, it’s calculated by taking non-interest expenses and dividing it by net revenue (“net revenue” because the revenue figure includes net interest income).
If a bank takes on more deposits, then this also means their interest expenses will trend upwards because of the increased interest payments they now owe. Therefore, an increase in interest expenses doesn’t necessarily reflect poorly on a bank.
All that’s left then is a bank’s non-interest expenses: the efficiency ratio measures how effectively a bank can use its non-interest expenses to generate revenue. Viewed another way, the efficiency ratio is a measure of a bank’s profitability.
Understanding the efficiency ratio may be a bit counterintuitive at first because a lower percentage is what’s desirable – experience tells us that higher efficiency is better, but that isn’t the case here. Remember, because of how the efficiency ratio is calculated, a lower percentage means non-interest expenses are lower compared to total revenue, which is what banks want to achieve, and is what investors want to see.
Assets/Equity Ratio: Degree of Leverage
We know that banks use their clients’ deposits, which are categorized as a liability, to finance the loans they extend, which are classified as an asset.
Companies taking on liabilities to finance their acquisition of assets isn’t abnormal. Recall that the Accounting Equation is presented as Total Assets = Total Liabilities + Total Equity. Put another way, companies can acquire assets either by shouldering liabilities (i.e., using borrowed money) or by using the funds provided to them by the owners of the company (i.e., those who have an equity stake).
Although companies finance their purchase of assets with liabilities all the time, it’s possible for a company to overextend itself and shoulder more liabilities than it can reasonably handle. Should a large portion of these liabilities come due all at once, then a company may find itself in a very sticky situation.
On the other hand, companies that can keep their liabilities on a tight leash when acquiring their assets stand to benefit handsomely. This is because they’re able to get the assets they need without having to put down large sums of their own capital.
When it comes to banks, how can investors measure how leveraged they are?
One method is to calculate the asset/equity ratio. As the name suggests, this ratio is calculated by taking total assets and dividing it by total equity. The higher the value is, the more leveraged the bank.
Just like any other metric, “high” and “low” are relative. Amongst Canada’s Big 5 banks, double-digit asset/equity ratios are the norm, whereas for American banks high single-digits/low double-digits are what’s commonly observed. These differences in ratios can be attributed primarily to a bank’s operating philosophy, risk management processes, and the regulations they’re subject to.
From an investor’s point of view, banks that can keep their asset/equity ratios near the industry and/or country average are good to see. Banks that can maintain a healthy ratio while simultaneously increasing their earnings demonstrate that they can make effective use of their assets without taking on more liabilities than needed.
Of course, just because a bank’s asset/equity ratio is at or very close to the average doesn’t mean there’s no room for improvement: the lower a bank can make that ratio, the better, because this means they’re reducing the liabilities they must shoulder, reducing the likelihood of a flood of liabilities crashing down on them.
Scope of Operations
Sometimes, all it takes for a bank to take a heavy hit to its financial health is for an unexpected economic/social event to happen. A housing market crash means a flurry of mortgages may suddenly become impaired, while a recession could mean some industries will be unable to repay their loans on time.
Any competently run financial institution will know better than to keep all its eggs in one basket and therefore should have adequate diversification of its revenue streams. Fortunately, many large financial institutions have already done this.
We know that, at their core, banks are loan-granting businesses, and when looking at the loan profiles of large banks it’s clearly visible that the loans they have are well diversified. In addition to having a variety of loans, many banks have some degree of geographic diversification as well, whether it’s serving clients all over their country, or even in countries around the world.
Financial institutions also further diversify their revenue by earning it from non-interset sources, such as insurance premiums, investment banking fees, and brokerage charges.
From an investor’s point of view, a high degree of revenue diversification due to an extensive scope of operations is usually good to see. This ensures that a financial institution can better withstand all sorts of macroeconomic, political, and societal changes without taking a major financial hit.
That being said, just because a bank has a wide scope of operations doesn’t automatically mean it’s financially invincible. A bank may have several business operations, but that doesn’t mean that all of them will contribute significantly to total revenue. Smaller competitors who focus on a specific financial service may prove to be more profitable than similar services offered by a large bank, such as insurance.
Diversifying sources of revenue is part of most large financial institutions’ strategies, but they’d be wise to pick their battles. A broad scope of operations is important to have, but by no means is it an excuse to become complacent.
Risk Factors and Challenges Faced by Banks
As long as people continue to need access to financial services, so too will financial institutions continue to exist. Because of this, it’s no surprise that successfully run banks can easily be in business for many decades or even centuries.
When looking at a bank’s annual report, there is usually a section dedicated solely to discussing the risks it faces, and how they are managed. These discussions are very comprehensive and are worth going over, however, not all of the risks that are talked about may affect investors or the investment merit of banks.
There are countless factors that can potentially impact a bank’s investment merit, so we will not be going over all of them (identifying every single one of those factors would prove challenging enough). That being said, there are some risk factors which are more prominent than others and can be detected and analyzed by most investors.
This section will go over some of those common risk factors.
Detrimental Changes in Macroeconomic Conditions
Although banks serve all sorts of clients, there is one factor that unites them all: they’re all affected by macroeconomic forces. Without going into too much detail, macroeconomics deals with the economy (usually on a national level) and covers topics such as GDP, productivity, consumption, inflation, policy interest rates, employment, taxes, and international trade, to name a few. Unsurprisingly, a bank’s operations are closely intertwined with the macroeconomic environment.
If one (or several) of these macroeconomic conditions were to take a turn for the worst, then banks may stand to lose quite a lot.
Let’s take policy interest rates for example. The policy interest rate is set by a country’s central bank; in turn, private financial institutions use this as a benchmark to determine what sort of rates they will charge on their own loans, such as mortgages.
On one hand, higher interest rates can be beneficial to financial institutions. Higher rates mean they stand to earn more interest income from their loans. However, higher rates also discourage clients from taking on new loans or place a greater burden on clients who have floating interest rates on their current bank loans (e.g. mortgages). If clients aren’t taking on new loans, or are unable to pay the interest on their current loans, then a bank’s interest income can take a very heavy hit.
Another example is unemployment. If a sizeable portion of a bank’s clients become unemployed, then a bank may experience a surge in impaired loans, late interest payments, or a decrease in revenue from other financial services that they offer. At the height of the COVID pandemic, this was a very real and serious risk that banks faced as countries around the world locked down and unemployment rates skyrocketed.
This section could go on endlessly as other factors are discussed, but that isn’t our goal here. Rather, the point here is to demonstrate that certain macroeconomic changes have the power to greatly impact a bank’s operations, and is something investors cannot afford to ignore.
Securities Experience a Sharp Loss in Value
While banks use a sizeable portion of depositor funds to finance their loans, a portion of those funds is used to purchase marketable securities, namely equities and fixed-income instruments.
Typically, loans make up a large portion of a bank’s total assets, while marketable securities usually take the second spot. However, there are exceptions to this.
In March 2023, California-based Silicon Valley Bank (SVB) collapsed, which marked the 2nd largest bank failure in U.S. history since the 2008-2009 Financial Crisis. For some, this collapse happened so suddenly. However, upon closer inspection, it became clear that collapse was inevitable.
Unlike other banks that use their deposits to extend loans and collect interest income, SVB used the bulk of its funds to purchase fixed-income securities, namely bonds.
Bond prices and interest rates are inversely related: if one goes up, the other goes down. That’s because when interest rates go up, the interest payments that newly issued bonds pay to investors increase as well. On the other hand, this means that older bonds that were locked in at a lower interest rate aren’t as valuable anymore, and as a result, their price goes down.
As interest rates rose sharply throughout 2022, and stayed persistently high in 2023, many of SVB’s bonds experienced heavy declines in value. At year-end 2022, SVB recorded losses in excess of $15 billion on its investment portfolio. If SVB needed to sell these fixed-income instruments in order to raise funds for client withdrawals, then they would be selling them at a major loss.
As clients began to question the strength of SVB’s balance sheet and their ability to make funds available, many clients began to withdraw their deposits, leading to a “run on the bank”.
Nobody knows for certain how financial markets will act in the future, but the level of investment risk that’s being shouldered can most certainly be managed. The collapse of SVB due to its failing investment portfolio is a clear demonstration of what happens when banks don’t have adequate risk management processes in place.
Banks that don’t detail what their investment risk management strategy looks like should immediately sound the alarm for investors. All it takes is for certain securities to tank for a bank’s balance sheet to be decimated.
Government/Regulatory Environment
By far the most pivotal event in the history of the banking industry was the Global Financial Crisis. Now, there were many institutions, individuals, and other parties involved in this complex event, but the party that attracted the most scrutiny by far was banks.
Following the crisis, measures were introduced to try and prevent such a crisis from happening again. In the U.S., the Dodd-Frank Act was passed, which introduced sweeping changes to the country’s financial services sector. Additionally, the Basel III regulatory framework was introduced as a direct response to the Crisis, with the expressed purpose of addressing the shortcomings in financial regulations that allowed the Crisis to occur in the first place.
Virtually every financial institution, whether it’s a local credit union or a multinational bank, is subject to government oversight and other regulations. From an investor’s point of view, this can be viewed in two ways.
On one hand, strong and effective financial regulations can ensure the stability of a country’s banking system, and because of this stability, attract and retain investment. An example of this is Canada.
Canada had strict financial regulations in place long before the Global Financial Crisis, which is overseen by the Office of the Superintendent of Financial Institutions (OSFI). Because of this, Canadian banks have been able to withstand all sorts of economic vicissitudes and consistently rank as some of the safest banks in the world. Therefore, it’s not surprising that Canada’s Big 5 banks have all been paying dividends without fail for more than 100 years.
On the other hand, overly draconian regulations and government oversight may hamper a bank’s ability to operate smoothly. Not only that but overly strict regulations may even impact the experience of current and potential clients, which could be a long-term problem for some banks.
In 2010, the U.S. signed the Foreign Account Tax Compliance Act (FATCA) into law. This law requires foreign financial institutions to search their records for clients who have connections to the U.S. (e.g. it’s their birth country, their tax residence, or they hold U.S. citizenship) and to report this client’s assets and reveal their identity to the Department of the Treasury. Additionally, FATCA also requires U.S. persons to disclose all non-U.S. financial assets to the Internal Revenue Service (IRS).
For people who reside primarily in the U.S. and keep nearly all their assets there, this isn’t much of a problem. However, this law can be a major problem for American expatriates who wish to open offshore bank accounts. This is because these foreign financial institutions don’t want to deal with the regulatory headache that comes with FATCA, so to avoid that, they simply refuse to take on American clients. Increasingly, European banks are giving the cold shoulder to American clients, choosing to give up potential clients rather than deal with more paperwork.
Any honestly run industry will need some regulation to ensure businesses and clients are protected, as well as to maintain some sort of order. However, overregulation can be just as detrimental as having none at all.
Investors will need to determine what sort of regulations a bank they’re interested in is subject to and to assess if this level of regulation will positively or negatively impact the bank’s performance, and by extension, its investment merit.
Shareholder/Societal Pressures
Many large financial institutions are publicly traded enterprises, and as a result, are closely watched by the public eye. Following the Financial Crisis and the role banks played in it, as well as British bank HSBC’s role in money laundering and other illicit activities, it’s not surprising that banks have drawn the ire of many people.
In recent years, a growing number of people are calling on banks to dramatically reduce or outright suspend their financing of oil and gas-related projects. These calls for action can take on the form of a public petition or a shareholder proposition brought before a bank’s Board of Directors, to name some examples.
Of course, banks aren’t required to listen to what the public has to say, no matter how much they raise their voices. Shareholder propositions are a good way to get a bank’s attention, but every proposition is put to a vote (which the Board of Directors can either recommend or discourage, with an explanation detailing why) – in order for a proposition to be acted upon, it must have enough votes in favour of it. Just because one group of shareholders puts forth a proposition doesn’t mean the others will agree with it.
That being said, although banks don’t need to listen to the public or act upon propositions that were shot down, they can only tolerate so much before they eventually fold due to overwhelming pressure and risk damaging their public image, or a persistent shareholder proposition finally garners enough votes.
From an investment standpoint, this can be a potential problem. If banks capitulate to external demands and pressure, two things can happen.
First, they may be giving up excellent sources of revenue in the process, potentially jeopardizing certain strategies and long-term goals. Second, an unwanted precedent is set demonstrating that, past a certain point, a bank will exceed its tolerance and will fold soon after – activists simply need to push until they reach that threshold.
Something that appears to make sense in the public eye may in fact be damaging to a bank’s operations, and as a result, negatively impact its investment merit. Ultimately, banks are responsible for answering to their owners (i.e. their shareholders), and ensuring shareholder value is either being improved or maintained.
Other Considerations to Keep In Mind
As the world becomes more digitalized and technology continues to play an increasingly important role in many people’s lives, the way people choose to carry out their banking is also rapidly changing.
Given how prolific internet access and mobile phones are in today’s day and age, many people are choosing to do their banking almost entirely through digital means. People can now open a bank account, transfer funds, and pay for all sorts of expenses entirely through their phones or computers. Many banks already offer many of their services online, but the challenge they face going forward is how to constantly adapt to clients’ ever-changing needs.
Although a bank’s online capabilities don’t directly impact its business health and investment merit, they can still be impacted indirectly.
If a bank’s online capabilities don’t meet client expectations, then clients will simply take their business elsewhere. Losing a handful of clients may not be a big deal, but if droves of clients do so, then that can be a very serious problem – fewer clients mean fewer deposits, meaning not as many loans can be made, therefore reducing interest income, and even non-interest income, that can be earned.
The rise of mobile and online banking has arguably brought a certain type of bank back into the limelight – direct banks. Direct banks offer all of their services through an online/electronic platform, and as a result, have no physical branches.
Because they don’t need to maintain a physical presence, direct banks have lower operating costs than traditional ones, and can therefore offer more incentives to clients, such as higher savings account interest rates and no (or at least very minimal) banking fees.
Although the financial services that direct banks offer aren’t as comprehensive as the ones offered by traditional banks, this doesn’t mean they are going to sit still. Direct banks are constantly adding to their suite of services, such as business banking, investment accounts, and even offering mortgages.
Investors who have capital tied up in traditional banks would be wise not to develop a false sense of security simply because the bank they’re involved with is bigger. If the bank they’re invested in is losing customers to smaller, leaner banks with enticing incentives, then an investor will need to find out what their bank is doing to counter this potential threat.
Wrapping Up
For most people, banks and the services they offer are an integral part of their financial lives, but beyond that, they aren’t really known for being “exciting” businesses. Investors, however, see things differently.
Despite being labelled as “boring” by most people, banks serve as a cornerstone in many portfolios because of their simple yet robust business model. As long as people continue to make deposits in banks, and as long as there are people and institutions that want to take out loans, then banks will always have customers to serve, and investors will always have rewards to reap.
Because banks are primarily loan-granting businesses, pertinent investment factors primarily look at how well they can extend loans and collect interest income, whereas risk factors look at ways that can be compromised.
As more people start to gain easy, affordable internet access, and as mobile phones become more accessible than ever, the way people choose to bank is quickly changing as well. Instead of wanting to see friendly tellers, people may now want more financial services to be offered at the push of a button.
This rapidly changing landscape may determine which financial institutions will continue to stay relevant in the future and is something investors may want to keep an eye on as well.
