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So as I mentioned in BlackHat's excellent post on how to break down a 10K (see here: http://www.wallstreetoasis.com/forums/anatomy-of-the-10-k), I'm going to put together a series of posts on how to evaluate a commercial bank. About me real quick, I work at a large US bank doing lending to & risk analysis of other banks (you can see my interview with WSO here: http://www.wallstreetoasis.com/blog/interview-with...). This series might have a credit-tilt to it, as this is my background, though for banks I think the credit-side and the equity-side are a bit closer than in other industries, and a lot of the analysis is going to be nearly the same (both generally follow CAMELS - capital, asset quality, management, earnings, liquidity, sensitivity to markets).

Feel free to ask questions and request items for me to touch on in future posts, but the structure of this series will probably be:

Intro/Industry Comments (this post)
Earnings
Asset Quality
Capital & Regulatory Matters
Liquidity & Funding / Conclusion

Basically, I'm going to walk-through the standard CAMELS analysis structure, but will talk a little about management throughout and will probably not go into sensitivity to markets too much, as it's less important than the other topics.

The focus of this is going to be commercial bank analysis (deposit-taking institutions). This is to be distinguished from bank holding companies that own a commercial bank, but also have large broker/dealer, insurance, or other subsidiaries (JPM, Citi, BofA, MS, GS). You can apply this analysis to these types of companies on a consolidated basis (as they are presented in their 10K), but things can get a bit cloudy due to large trading books. It is also important to understand that since banks are highly regulated, money may not be able to flow between these different subsidiaries (and to the bank holding company), which can make things tough. This series should help in starting to look at these type of companies as well, but they are much trickier. You can get information on just the commercial bank portions of these companies (as well as any US bank) from the FDIC: https://cdr.ffiec.gov/public/

I'm probably going to pick out a specific regional bank ($10Bn to $150Bn in assets) to walk through for this, so I can pick out specific parts of their 10K / FDIC call report. I haven't decided which one just yet, however (feel free to make requests, no guarantees I choose a requested one though).

A few things first:
Banks are different from your typical corporate (manufacturing/tech/retail/etc) due to the way they earn money and the very specific way their balance sheets are constructed, both of which lead to them being more highly regulated than any other industry (and maybe all other industries combined). We'll get into this in more detail, but banks make money primarily by acting as intermediaries between people who are saving money (deposits) and people how are borrowing it (loans/securities - taking credit risk), making a spread by investing and borrowing at different points on the yield curve. They also perform other services that generate fee income (this whole I-banking thing, asset management, trust, processing, and other businesses), but a large part of a banks earnings (almost always more than 50%) are derived from using their balance sheet directly. This is different from a corporate who is making something tangible to sell for cash, and their balance sheet is more of a residual reflection of their business model rather than the direct producer of earnings (if that makes sense - financial vs historic cost assets). Because a bank's earnings are mainly interest, we also can't use typical metrics like EBITDA or DCF models to value them, as banks are basically entirely cash flow and we can't excluding interest income/expense from the picture (we also don't really care about the cash flow statement).

This leads to the equity /specific balance sheet structure part (and ECF method for valuation). Banks need to be highly leveraged because banks don't really make that much money off of their assets/operations (a few % interest), but they still need to generate sufficient ROE in order for investors to want to do all of this in the first place. A typical/decent bank only generates about 0.75% to 1.5% return on assets, meaning that to meet their WACC, they need to have about 10x to 20x assets to equity (this can even be higher in some cases - mainly Europe). This level of equity that they hold is highly regulated because (as opposed to corporates that can even run in deficit) most of their assets/liabilities are financial assets that are at fair value (or in the case of loans nearly fair value). They need to hold specific levels of equity against the riskiness of the assets (likelyhood they decrease in value), so that the liability holders (mainly concerned about depositors) don't get whipped out if the equity is consumed by losses. Capital runs too low, regulators take the keys away. This all ties back to the ECF method (or dividend discounting) because we need to make sure of a few things before we can assume that the bank is going to make income, or that they will be able to return any of it to shareholders. Hence, we look at CAMELS: the capital adequacy, the asset quality (how risky / prone to loss they are), how management deals with this highly leveraged, risk-taking entity, the bank's earnings power (ability to build / destroy capital), their sensitivity to markets (and proneness to lose earnings/capital in them), and the final part is liquidity/funding, which is a somewhat different issue that can also lead to a bank closing shop. How to look at each of these aspects is what I'm going to walk through in later posts. The nice thing about all of this is that, unlike other companies, banks are very similar to each other, can be easily compared, and the same techniques can be used for measuring their performance.

A few notes about US Banks:
The banking system in the US is quite small (~80% of GDP) compared to most other developed countries (systems around 100-200% of GDP, or even more). This is because the US corporate debt and mortgage securities markets are much bigger than in other countries, and investors, not banks, hold a much more significant amount of the debt in the system. The largest US Banks are also much smaller relative to GDP than other banks in the world (for example to make JPM the same size as BNP Paribas relative to France, JP's assets would need to be about 5x as large). This is a good thing, because it makes it easier for the gov't to prevent a systemic crisis that could harm the economy (like in 2008, though it appears everyone is dead set on martyrdom if that ever happens again). The US banking industry is also much much much less consolidated than others, with ~7000 banks in the country (many with just a few branches). This leads to difficulties in regulatory process, and US regulators have a much more difficult time implementing new rules / international standards than their counterparts, which I'll discuss more in the capital post. That being said, the general quality of public disclosure and regulatory oversight is much higher in the US than in many areas, making US banks a lot easier to analyze.

This may seem pretty intuitive, but it must be said - banks are often direct reflections of the performance of the economy in which they operate/lend. This should be pretty straight forward: economy bad = people/companies have less money = tougher time paying loans = losses for bank. This has several implications. First, an analyst needs to understand the conditions being faced by the bank's borrowers. Second, if all of these borrowers are in the same place / facing the same conditions, things can get ugly faster. This means banks should try to diversify their lending by loan type, industry, and geographically. The problem in the US is that a lot of the small banks aren't able to do this, and small banks tend to fail at all points in the national economic cycle (let alone a national downturn). For analyzing foreign banks, it's extra important that the analyst understands the economic conditions in the country, foreclosure laws, reporting standards, etc, which generally makes looking at foreign banks a bit trickier.

I'm getting kind of tired, but I hope that this post makes sense and works as an intro to bank analysis, and how it is a bit unique. I'll hopefully start working on something about how to looking at earnings over the next few days. Feel free to ask questions for now and I'll try to clarify things that don't make sense.

6

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Comments (23)

  • Sandhurst's picture

    Happy that someone finally did this. Will give it a read shortly.

    "There are three ways to make a living in this business: be first, be smarter, or cheat."

  • Simple As...'s picture

    Nice. Thanks!

    patternfinder:
    Of course, I would just buy in scales.

    See my WSO Blog | my AMA

  • Vagabond85's picture

    Very nice. I've looked at banks in other countries and have struggled with distinguishing between development, private and publicly owned banks in terms how to account for government support (implicit or explicit) during security valuation. Any thoughts? Specifically, in when the support should override poorer fundamentals or maybe even a framework for thinking about it?

  • voetbalwizard's picture

    this is going to be a superb series. Looking forward to it pirho.

  • Dubya's picture

    This is amazing, thank you.

    ''You can fool some of the people all of the time, and those are the ones you need to concentrate on.'' -- President George W. Bush
    0.5 bb

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  • BatMasterson's picture

    Salient intro, thanks.

    "I like money (as do most females) but love is...great :)"-student
    "Perhaps you've failed to take into account my hidden assets"-007
    Looming Hurricaine

  • meabric's picture

    do you cover ADS or other CC names (or banks with significant CC operations, Capital One comes to mind). Any quick primers on quality of earnings, with a focus on how to evaluate both portfolio quality and spreads vs. funding costs.

    Also, do you think evaluating credit as a counterparty (which is my reading of your job) is different from as an investor (since its return free risk)?

  • In reply to Vagabond85
    TDSWIM's picture

    Vagabond85:
    Very nice. I've looked at banks in other countries and have struggled with distinguishing between development, private and publicly owned banks in terms how to account for government support (implicit or explicit) during security valuation. Any thoughts? Specifically, in when the support should override poorer fundamentals or maybe even a framework for thinking about it?

    I'm also curious about this.

  • gregt14's picture

    Didn't really read the entire thread but working in a solid Community/Regional Bank, I can speak on the main things Banks are struggling with and how to decipher the strength of a Bank. Most of this is no-brainer stuff but thought I would comment.

    The main data people always start at when looking at Banks is ROA and ROE - although there is a school of thought that after the recession these figures now have a new standard which shouldnt be compared to historical figure pre Dodd-Frank.

    A very current issues small-to-mid size Banks are working with is a significant decline in Net Interest Margin or NIM caused by historically low interest rates on debt - I mean, Banks cant pay less than zero on the checking/savings that they are already are doing, so the only thing left to go lower is rates on the debt. I would heavily look at the trend of a Bank's NIM and how they are implementing other fees (deposit, etc) to offset the loss.

    Of course the other main number for Banks is Operating Efficiency which is the OPEX as a % against gross revenue. This, along with ROA and ROE are probably the baseline things to look at.

    But like I said, NIM is at the core of issues for Banks right now. Big Banks can absorb it more with other fees generated from other lines of business. But smaller Bank live on the NIM and if they cant figure out a way to generate revenue from other sources and rates stay at historic levels for another 2-4 years, it will create a major problem. Throw in an unexpected charge-off and you have a failing Bank. So look at the non-performing asset ratio as well.

    Like i said, basic bread and butter stuff. Just thought I would comment since I am living it. Our Bank has been heavily focused on generating revenue from Treasury Management, lowering rates on EVERYTHING, implementing other fees upon closing a transaction, implementing SWAPS which also guards against a rise in interest rates, etc. My Bank is consistently ranked among the highest for Safe and Soundness and for performance in California. We have approx $2B in assets.

  • CBSWannabe's picture

    i enjoyed the write up

  • In reply to Vagabond85
    Pirho's picture

    Vagabond85:
    Very nice. I've looked at banks in other countries and have struggled with distinguishing between development, private and publicly owned banks in terms how to account for government support (implicit or explicit) during security valuation. Any thoughts? Specifically, in when the support should override poorer fundamentals or maybe even a framework for thinking about it?

    Well this is sort of the $64,000 question these days. I think for development banks that are explicitly guaranteed (or anything explicitly guaranteed) you are going to mainly just consider the sovereign's credit profile. Any default by an explicitly guaranteed institution is really going to freak the sov market out, and really isn't an option unless the country itself is in severe distress. Implicitly guaranteed gets a bit trickier. I like to look at the role they play (who they lend to), their size, and then consider which sov you're dealing with and their credit profile. Most of the time, sovereigns will head off any weakness at development banks in advance or will make statements of support. Even the default/deterioration of an implicitly supported dev bk can be seen as a sign of weakness at the sov, and could freak the sov debt market out, so it's usually avoided.

    Gov't owned banks is where it can start to get a bit trickier. Typically a gov't owned bank is going to have some explicitly stated guarantee scheme or plan to recapitalize it / return it to the market and you'll have a handle on that time frame for when you can expect to look at it on its own. In those cases most people assume the sov credit profile applies and that the guarantee/plan is basically explicit support, as banks worth being taken over are typically systemically important, and the country can't let them fail w/o a major crisis unfolding. It gets tough when the sovereign is weaker and the bank is large / weak, then you have to do somewhat of a hybrid analysis (bank + sov - like what's going on in Slovenia now). As the sov gets weaker, support gets less likely, and the credit profile of the bank reverts to its stand-alone rating.

    Support for regular banks is tough and depends a lot on the political attitude in the country, past experience, and the ability of the country (credit / size of the banking sector) to conduct a bailout. The thought currently is that equity holders are at complete risk everywhere, as are sub-debt holders. Sr debt / uninsured depositors is where things are pretty grey right now. I think people "hope" that as long as it's a strong sovereign taking the bank over, these sources of 'bail-in' still won't be touched, but that view is being challenged, and the safety might be a bit lower now than previously (probably also depends exactly the scale of the re-cap needed and how far into the cap structure a bail-in needs to go). This also largely depends on the bank and its role in the system. Usually, I start thinking a bailout might be possible if a bank is around 5% or so of deposit/lending share, 10% pretty likely, 15-20% pretty much certain, >25% necessary or the country is probably in trouble. Again, this probably depends on the specific situation and the interbank linkages in the country, but everyone is still vividly aware of the problems a lock-up in the interbank funding markets can cause.

  • In reply to meabric
    Pirho's picture

    meabric:
    do you cover ADS or other CC names (or banks with significant CC operations, Capital One comes to mind). Any quick primers on quality of earnings, with a focus on how to evaluate both portfolio quality and spreads vs. funding costs.

    Also, do you think evaluating credit as a counterparty (which is my reading of your job) is different from as an investor (since its return free risk)?

    I don't specifically cover any of these names, but you'd want to look at charge off rates, delinquencies, net interest margins/yields, historic loss rates, efficiency, debt maturities (CC companies usually have alot more debt than banks), etc.

    Not really sure what the second part means. Could you clarify? What type of investor and what do you consider "return free risk"?

  • In reply to Pirho
    Vagabond85's picture

    Fantastic, great insights. This framework will prove very useful in my work going forward. Greatly appreciate it- SB for you sir.

  • IntlPlayer's picture

    You read my mind with this one....I also work in this space....but for foreign banks.

    This subject matter is so interesting because it outlays how this whole thing (global economy) works.

    And you're right. It is hard for smaller banks. They ramp up their balance sheet growth doing real estate deals (asset, fixed rate). But as typical with banks, they're funded with with shorter term liabilities (more variable repricings). If rates go up and they can't reprice those loans but have to reprice those deposits/funding sources, there goes those margins. Also, since most of them have limited trade territories, they tend to have all of their real estate projects concentrated in the same geographic area. If that area goes bad, they all go bad.

  • StocksandBlondes's picture

    I am going to work for the commercial lending group of a BB bank and I feel like this has given me good insight into what I am going to be looking at. Also, the idea of working in a group that lends only to other banks is intriguing

  • In reply to gregt14
    Sandhurst's picture

    gregt14:

    A very current issues small-to-mid size Banks are working with is a significant decline in Net Interest Margin or NIM caused by historically low interest rates on debt - I mean, Banks cant pay less than zero on the checking/savings that they are already are doing, so the only thing left to go lower is rates on the debt. I would heavily look at the trend of a Bank's NIM and how they are implementing other fees (deposit, etc) to offset the loss.

    I've been hearing talk thrown around about negative interest rates (on deposits). I think CS has instituted/will be instituting them for some types of accounts, actually.

    "There are three ways to make a living in this business: be first, be smarter, or cheat."

  • In reply to Sandhurst
    Pirho's picture

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  • Gstar88's picture