Evaluating Commercial Banks (part 1 of ??)

So as I mentioned in BlackHat's excellent post on how to break down a 10k (see here: //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: //www.wallstreetoasis.com/blog/interview-with-credit-risk-associate-part-…). 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.