Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ====== Banking ====== Banking is the business of being a trusted caretaker of other people's money. At its heart, a bank is a [[Financial Intermediary]] that accepts [[Deposits]] from individuals and organizations and then uses that money to make [[Loans]]. This simple-sounding process is the circulatory system of a modern economy, channeling capital from those who have it (savers) to those who need it (borrowers) for everything from buying a home to starting a business. Banks make their profit primarily from the "spread"—the difference between the [[Interest Rate]] they pay on deposits and the higher interest rate they charge on loans. This core activity is supplemented by a variety of fee-based services, such as wealth management, currency exchange, and payment processing. Because banks operate with a very small cushion of their own money relative to the vast sums they handle, their health and stability are critical to everyone, not just their shareholders. ===== The Business of a Bank: A Tale of Two Spreads ===== Imagine a bank as a unique kind of merchant. Its inventory isn't cars or clothes; its inventory is money. Its fundamental business model, known as [[Fractional Reserve Banking]], involves a mantra as old as finance itself: //"borrow short and lend long."// A bank borrows "short" by taking in deposits, which customers can typically withdraw on short notice. It lends "long" by issuing multi-year mortgages and business loans. The profit engine here is the [[Net Interest Margin (NIM)]], which is the difference between the income generated from loan [[Assets]] and the interest paid out on deposit [[Liabilities]], expressed as a percentage of the bank's assets. A healthy, wide NIM is often a sign of a profitable banking operation. However, banks are not just one-trick ponies. They also generate non-interest income from a vast array of fees. These can include: * Service charges on checking accounts. * Fees for overdraft protection. * Commissions from wealth management and brokerage services. * Fees for originating mortgages. For an investor, it's crucial to understand this mix. A bank heavily reliant on a strong NIM is sensitive to interest rate fluctuations, while a bank with strong fee income may have a more stable, though perhaps less spectacular, earnings stream. ===== How to Analyze a Bank: A Value Investor's Checklist ===== Analyzing a bank is fundamentally different from analyzing a manufacturing company or a tech startup. For a bank, the balance sheet isn't just important; it's //everything//. The product is risk, and the quality of that product is difficult to see from the outside. As Warren Buffett noted, the seeds of a bank's destruction are sown in good times when lax lending standards go unnoticed. ==== Understanding the Balance Sheet ==== A bank's balance sheet is inverted compared to a normal company's. Your deposit is your asset, but for the bank, it's a liability—they owe it back to you. Conversely, the loan they give to your neighbor is their asset. Because banks lend out most of the money they take in, they are highly leveraged. [[Leverage]] magnifies returns but also magnifies losses. The thin slice of the bank's funding that comes from its owners, rather than depositors, is its [[Equity]] or [[Capital]]. This capital acts as a crucial buffer to absorb unexpected loan losses. Regulatory frameworks like the [[Basel Accords]] set minimum capital requirements to ensure banks can withstand financial shocks. ==== Key Performance Metrics ==== When sifting through bank financials, value investors focus on a few key metrics that cut through the noise: - **Price-to-Book (P/B) Ratio:** This compares the bank's stock market valuation to its net worth as stated on the balance sheet. For banks, it's often more insightful to use the [[Price-to-Tangible-Book-Value (P/TBV)]] ratio. [[Tangible Book Value (TBV)]] excludes intangible assets like goodwill, providing a more conservative measure of a bank's liquidation value. A P/TBV below 1.0 //could// signal an undervalued bank, but you must first be confident in the quality of its assets. - **Return on Equity (ROE):** Calculated as Net Income / Shareholder Equity, [[Return on Equity (ROE)]] measures how effectively the bank is using its owners' capital to generate profits. A consistent ROE above 10-12% is generally considered strong, but it must be viewed in the context of leverage. A very high ROE might signal excessive risk-taking. - **Return on Assets (ROA):** Calculated as Net Income / Total Assets, [[Return on Assets (ROA)]] measures profitability relative to the bank's entire asset base. Since bank assets are enormous, the ROA is typically low. An ROA of 1% or higher is a common benchmark for a well-run U.S. bank. It's a great indicator of operational efficiency before the effects of leverage. - **Efficiency Ratio:** This metric (Non-interest Expense / Revenue) reveals how much a bank spends to make a dollar of revenue. A lower ratio is better. A bank with an efficiency ratio in the low 50s is likely running a much tighter ship than one in the high 60s. - **Asset Quality:** This is the hardest part to judge. Look for the level of [[Non-Performing Loans (NPLs)]]—loans where the borrower has fallen significantly behind on payments. Also, check the adequacy of the bank's [[Loan Loss Provision]], which is money set aside to cover expected future loan defaults. Conservative banks provision generously, even in good times. ==== Management and Culture ==== More than in almost any other industry, management's character matters. A great bank is run by prudent, risk-averse managers who think like owners, not speculators. They prioritize a fortress-like balance sheet over short-term earnings growth. Avoid banks led by empire-builders who pursue risky acquisitions or chase the latest financial fad. The best bankers are often a bit boring—and in banking, boring is beautiful. ===== Risks: The Dark Side of Banking ===== Investing in banks requires a clear-eyed view of the risks, which are ever-present and interconnected. * **Credit Risk:** The most fundamental risk. If a bank makes too many bad loans that default, its capital can be wiped out, rendering it insolvent. This is what happened to many institutions during the 2008 financial crisis. * **Interest Rate Risk:** The "borrow short, lend long" model can backfire. If interest rates rise suddenly, a bank's funding costs (what it pays on deposits) can rise faster than the income from its fixed-rate loan portfolio, crushing its Net Interest Margin. * **Liquidity Risk:** This is the risk of a classic "bank run." If depositors lose confidence and rush to withdraw their funds all at once, a bank can be forced to sell assets at fire-sale prices to meet redemptions, leading to its collapse. Deposit insurance schemes, like the [[Federal Deposit Insurance Corporation (FDIC)]] in the U.S., were created to prevent this. * **Systemic Risk:** The financial system is a web of interconnections. The failure of one large bank can trigger a cascade of failures across the industry. This is why major banks are regulated by [[Central Bank]]s like the [[Federal Reserve (The Fed)]] in the U.S. and the [[European Central Bank (ECB)]], which act as lenders of last resort to maintain stability. ===== Capipedia's Bottom Line ===== Banking is a business of trust, leverage, and cycles. For the value investor, the goal is to find straightforward, well-managed, and conservatively financed banks that are trading at a sensible discount to their tangible book value. Be wary of complexity; if you can't understand a bank's balance sheet or its strategy, steer clear. The best banking investments are often found in simple institutions that stick to the basics: taking deposits and making prudent loans in a community they understand. In banking, patience and a focus on risk protection will always triumph over aggressive growth and financial engineering.