# Valuing a bank made simple: leverage and risks

Chandan Dubey
Mar 24, 2012
In the last article, Valuing a bank made simple: balance sheet we saw how a bank makes money and what are the different items on its balance sheet. We pointed out and defined the things we see in a bank's balance sheet.

In a very simplified form, a bank takes deposits from savers and passes these funds to the borrowers. It pays a bit of interest on the savings by the depositors and charges a much higher interest on the funds given to the borrowers. The difference between the interest yields provide the profit for the bank. In some sense, this can be seen as compensation for the risk of providing credit to the borrowers.

### Leverage and risk

I would like to say something about the debt in the banking industry. There is a cut-throat competition between the banks to poach customers away from each other. Why would a customer move from bank A to bank B ? If he is a saver, he can be enticed away by offering superior yield on his savings. If he is a borrower, he can be poached by offering lower interest rate on the borrowings. The bank may offer superior customer services and may also pose as a secure bank. But these are largely un-noticed by a common saver or a borrower. In this sense, banks offer a very commoditized service.

Explaining leverage is easier done by an example. Let us suppose that you have \$100 in your pocket (this is equity). You can invest your \$100 at 6% yield ie., you can expect to make 6% every year on your investment. But being greedy you are not satisfied with a 6% yield. Your neighborhood banker comes to the rescue. He offers to give you money at a 5% interest rate. So, you take on a debt of \$400 (liabilities) from the bank and you invest \$500 (asset). You expect to get 6% every year. After paying the interest to the banker, you will get a profit of (\$500*0.06-\$400*0.05=) \$10. This is a 10% yield on the \$100 you invested. This is called leverage. A way to measure the financial leverage is the asset-to-equity ratio. In this case, you financial leverage is \$500/\$100=5.

This is all very good. But things can go wrong. Nothing in investment, as we know, is very predictable. Let us see what may go wrong.

• Lower yield on investment: Suppose that the investment you made, had a lousy year. It only returned 4% this year. How much money will you make now ? Well, from our calculations, you have to pay \$400*0.05 to the banker, which is \$20. On the \$500 investment you made 4% yield, which is \$500*0.04, \$20 again. So, you have nothing left. Your return on the \$100 investment was a big fat 0%.
• Loss on investment: Now suppose that this was a really bad year for the investment. Something which happens in a decade or so. You had a 20% loss in your investment ! Well, the banker does not care. You are contractually obliged to pay him \$20 (a 5% yield on the loan of \$400 you took). Your \$500 investment is worth only (\$500-\$500*0.2=) \$400 now. After paying the banker \$400 that you owe him, with \$20 in interest you are \$20 in debt ! You lost your original investment of \$100 and some (\$20 in debt). If you had not leveraged your \$100, after a 20% loss, you would have \$80 in your account.

There are two things to learn from here. If you are in an industry where the return on the asset is small, you must leverage to get an acceptable return on the equity. The second lessons is that the leverage can come to bite you in some circumstances.

We saw in the last article, banks expect to get anywhere between 0.5% to 1% return on the assets they own, after paying their depositors and creditors. This is a very low yielding industry and if the banks only ran on equity and no leverage, they would earn the same return as the return on assets. An investor will be better off putting the money in the treasury than opening/investing in a bank.

To make this worthwhile, the bank has to leverage its balance sheet. We saw that STD was leveraged 15 times the equity. That is, STD has \$1 of its own money for every \$15 in assets. The assets are invested in loans, bonds, treasuries, securities and so on. A 1/15(=6.66%) loss on the invested assets will wipe out the equity as it will have \$14 for every \$15 in assets after the loss and it owes \$14 to the creditors.

### Measuring risk: Basel Accords

Given the risks of leverage and the intrinsic need for banks to be a leveraged business, it was found necessary to come up with a way to measure risk and require the banks to maintain sufficient amount of liquidity.

The Bank of International Settlements (BIS) in Basel, Switzerland is an intergovernmental organization of central banks which serves as a bank for central banks. The BIS has played an important role in forcing the banks to maintain sufficient margins of safety to stop a golbal financial meltdown.

The largely defunct Basel I agreement from 1988 is the one I am going to describe now. This will give you an idea of how the banks are forced to maintain a moderately leveraged balance sheet. It will also give you an idea of how the banks measure risk and explain the buzzwords that are used now. Basel I was superseded by Basel II in 2004 and global banks have until 2019 to de-risk their balance sheet to confirm with Basel III which was agreed upon in 2011.

Basel I: Defining risk

Basel I lumps all of banks assets into risk categories. The risks vary from 0 for treasuries to 100% for corporate debt. See the table below.

 Asset type Risk Cash and gold in bank, Treasuries, Government debt 0% Securities issued by govt agencies or municipalities, claims on banks that are from the countries in Organization for Economic Cooperation and Development (OECD) 20% Residential mortgages 50% Public sector debt 0-50% Claims non-OECD bank, treasuries of less developed countries, corporate debt, equities, real-estate, property plant and equipment 100%

Using these weights the assets of the banks are calculated using the risk weight, called Risk Weighted Assets (RWA). According to the Basel I, the capital of the bank should be at least 8% of the RWA. Let us take an example of an imaginary bank and its assets. We will use 8% as the capital ratio as in Basel I.

 Asset type Amount Risk weight Risk weighted asset Capital requirement Treasuries \$1000 0 0 0 Municipal bonds \$1000 20% \$200 \$16 Mortgage \$1000 50% \$500 \$40 Equities \$1000 100% \$1000 \$80

As one can expect, the Basel I was too simplistic and had various drawbacks. The lumping of several different things into one category is not very smart. For example, the greek debt will get a 0 risk weight but it is one of the most riskiest assets at the moment. The risk calculation does not take into account the market at all and is a stable measure (does not change if the market goes up or down).

The Basel I agreement was also obviated by banks as they took insurances on their riskiest assets and sold the risk to other investors. This gave a false sense of stability to the balance sheet as we now know. Basel II and then Basel III fix some of these problems and loopholes.

If you look at the financial statement of a bank, they throw terms like Tier 1 capital and Tier 2 capital and we need to understand what they are to see what exactly they say about the stability of the bank.

Tier 1 Capital: Tier 1 capital includes common stock and disclosed reserves (may include retained earnings). It may also include preferred stocks. Banks have been very creative in coming up with instruments to generate Tier 1 capital. Basel II and III have consequently put an upper limit of 15% on the core capital which is generated from creative accounting.

Tier 2 Capital: This is supplementary capital. For example, the subordinated debt which ranks after all other debts if the company falls into bankruptcy, can be counted in Tier 2 capital. Hybrid instruments which have properties of both equity and debt can also be counted here.

A very famous type of hybrid instrument which was used quite a bit during the crisis is CoCo bonds (convertible bonds). This types of bond can be converted in common stock or in cash at an agreed upon price. JPM has issued \$21B in CoCo bonds.

In the next article, I will concentrate on the management of a bank and how important it is to concentrate on them while valuing a bank.
Rating:

I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.

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