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Chandan Dubey
Chandan Dubey
Articles (150) 

Valuing a bank: growth, asset quality and management

April 14, 2012 | About:

The banks are suffering again and this gives me a very good opportunity to increase my understanding of their business. After looking at the balance sheet and the leverage of a bank, today we are moving to more interesting things. In this article, I will look at ways to come up with an idea of how a particular bank does its business. Understanding the business model, the lending practices, the growth the bank expects is very important before jumping in. This will be a differentiator between a good and less speculative investment to a haphazard and highly speculative one.

If within reasons we can come up with a way to measure the management and the business model of a bank, then we will have a better confidence in putting our money in the bank. Let us look at these issues in more detail.

Measuring growth

Deposit growth is one of the first things to look at. The historical figure will tell you if the bank has been able to attract money from its customers. As we have seen and discussed before, customer deposits are the cheapest way for a bank to get money. If a bank is not getting enough raw material from customers, it will have to borrow funds from less attractive venues, like debt offering, equity offering, or borrowing from other banks.

A healthy growth in the deposits on the other hand bodes well for the bank. This means that the bank has access to cheap money which it can use to grow.

Loan growth is also very important. If the loan growth is sluggish, the bank will have trouble earning money on the spread between the interest it pays on the borrowed money and the interest it is paid on the loans (the basic banking business).

Obviously, one needs to be careful. We don’t want the bank to loan money to unscrupulous borrowers. In this case, the bank may lose all the money and may have to write off the loan, hurting the earning. If a bank makes enough bad loans, it may go bankrupt because of the high leverage the banks have.

Clearly, we would also like to see the growth in the (interest income - interest expense). The larger the spread, the better it is for the bottom line and the EPS. Both of these are in some sense effected by the government regulations. A bank cannot price the interests on the loans to be outrageously high. This means that the only way to grow the spread is to grow deposits as well as the loans. The difference between the interest income and interest expense, in terms of percentage, is called net interest margin. As we mentioned earlier, we would like to see a high net interest margin. Comparing banks within similar business models will let you sort out the ones with higher interest margin from the ones with lower ones. But this is not enough. A higher net margin can be a sign of a great management OR risky lending policy. Similarly, a narrow margin can mean higher cost of funds OR conservative lending practices. One must decide which is which to make an informed decision.

Loan loss reserves

Loans are the biggest part of the assets a bank has. These are the things which make money for the bank. The quality of the loans given by the bank is very important. If people do not repay the interest and worse still the loan itself, the bank will have problems. But lending entails assuming risk that the loan will not be repaid. The idea is to reduce the possibility by making conservative loans. Banks maintain a loan loss reserve to write off the bad loans which probably will not be repaid and must be taken off the book as a loss of capital.

Let us see how this works in a bit more detail. A bank has a loan loss reserve. The loan loss reserve at a given moment reflects the management’s educated estimate of the bad loans on its books. When a bank decides that a particular loan is in default, it does not directly charge-off this loan from the earnings, but it charges it off against the loan loss reserve. A charge-off reduces the loan loss reserve. How is it replenished then ? Banks adjust the loan loss reserve by making non-cash provisions (like expense which reduces earnings). To summarize, loan loss provision adds to the reserve but also reduces earnings. A charge-off of a bad loan reduces the reserve but has no effect on the earning. Recovery of a past loan which had been written off increases the reserve and again has no effect on the earning. The idea behind having a loan loss reserve is to not have wildly swinging earning. If the write-offs are charged directly against earnings than the bank will have very good earning when the economy is doing great (good earning and less charge-offs) and very bad ones when the economy tanks (bad earnings and large charge-offs).

How does the bank come up with a figure for its reserve ? For coming up with a figure for the loan loss reserve the bank looks at the financial capacity of the borrower, the value of the collateral behind the loan (if any), the situation the economy is in (default increases if the economy is in a slump), the industry the borrower is in and other statistical and subjective tidbits. This is not an exact science and even a very conservative management can be duped by unscrupulous borrowers. The size of the reserve also tracks the economic cycles. In the time of economic hardships the loan reserve rises to absorb the large number of defaulting borrowers. On the other hand, when the economy is good the chance of a default is smaller and hence the bank may have a lower reserve.

In the past, some banks have kept zero or negative provision for the loan loss reserve. This way they were able to subtract money from the reserve to pad their earnings.

Ideally, when the economy is good the banks become a bit lax with their loaning practices and this is the time when they make loans that have a larger chance to default. So, they should build a larger loan reserve in a better economy and draw it out when the economy is worse. Surprisingly, the situation is just the opposite. When everything is going well, the banks have a declining reserve and this implies that the earnings of the banks are overstated (they should be less if a commensurate provision for loan losses were made). There is no sign of this changing anytime soon.

Valuing the asset quality

A bank’s assets are its loans. By the quality of the assets we want to figure out if the loans are good and will be repaid in due time or they are bad and will result in a default. As this is very difficult to do on a loan-by-loan basis, an investor is left with looking at the history of the bank. We want to figure out if the management has been conservative in making loans. The lower the loan write offs, the better we are. It is important to look at the history for at least 10-15 years to have a good idea of how the bank manages its reserves during economic cycles.

The things to look out for are “charge-offs”, the ratio of loan loss reserve to total loans, and the ratio of nonperforming loans to total loans. Looking at the trend will allow you to have a good idea of the asset quality. This is because we are not really trying to determine the quality of the loans, far from it ! We want to judge the management. When investing in a bank, we are investing in a group of people with a particular money making scheme. We must verify that their scheme has worked in the past. If the charge-offs are consistently small compared to the total loans on the book, then the management is good and you can feel comfortable that they have made conservative loans in the past and will probably do the same in the future. There will always be risks but looking at the history and the trends, we will be able to minimize them.


Liquidity is the amount of money the bank can come up with, on short notice, without loans or borrowing from anywhere. When the going gets tough, no-one will want to lend their money and liquidity is the stuff that is going to separate a dying bank from a healthy one.

If a bank is very liquid and has a lot of cash in hand, it can jump on good opportunities and invest its money. This is similar to how we manage our portfolio. Having a large amount of cash will lead us to buy bargains when the market is running scared. The problem is that banks loathe to keep cash. To earn money the bank needs to lend out money. The money in the vault is losing its value as the bank needs to pay interest on it.

A bank must find a balance. Ideally, the liquidity should increase when everything is going great. This will lead to a good cushion against market crashes and the bank will have enough cash to respond quickly when a good deal comes by.

There are two quick ways to check the liquidity of a bank. The first way is to look at the percentage of assets held in cash and treasury. The second is loan to deposit ratio. A high loan to deposit ratio means that the bank may not have sufficient liquidity. A small loan to deposit ratio means that the bank may not be earning as much as it can on the funds it has. For most well capitalized banks, the loan to deposit ratio should be around 100%. To come up with a better understanding one should look at this figure for several banks in similar industries.

Measuring performance

It is a good idea to invest with people who have performed well in thick and thin. Given a specific amount of capital, we want to figure out how the management has managed it. Return on equity is a bad measure for banks. This is because the banks are highly leveraged and the leverage varies across sector. For example, the RoE of WFC has varied from 4.12% to 19.69% in the last decade. Also, STD has managed to be in the range of 3.62% and 18.23%. But WFC has done so being a lot less leveraged than STD. A bank with very high RoE (in the range of 27-35%) means that it may be making bad loans and not making sufficient reserves in case of a rainy day. It may also mean that the bank is more leveraged than it should be. So, a high RoE is a warning sign and should be looked into in more detail.

A better measure of performance is the return on invested capital (RoIC) and Return on Assets (RoA). These are leverage neutral in the sense that it looks at returns on all the assets which the bank is employing to achieve the return. Higher the RoIC/RoA, better the management is performing. Obviously, it is not as clear-cut as this but coupled with conservative lending practices, good liquidity and manageable leverage, we have a recipe for side-stepping bad management and a crappy bank.

About the author:

Chandan Dubey
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.

Rating: 3.7/5 (21 votes)


BEL-AIR - 5 years ago    Report SPAM
This was a good article, it was very informative.

You are very informative at looking at banks.

Chandan Dubey what do you think of HCBK?

HCBK, & WFC are two banks I been watching.

In the past both of these banks have been more conservative then most.

Thank you for such great articles.
Vgm - 5 years ago    Report SPAM
It's of course necessary to understand any business we're interested in, but your opening gambit "The banks are suffering again..." is perplexing.

Banks have been thru tough times in the past few years, for sure, but they are emerging again, changed and cleaned up to a large extent. It's universally agreed they will be less profitable going forward, as Buffett has commented many times, but in a recent interview he also stated that US banks were in better shape now than they have ever been. The results from JPM and Wells just two days ago would certainly support that point of view.

The situation with European banks is very different - they are not yet cleaned up. A superficial comparison of Wells and STD is not meaningful in my opinion.

Seems to me you're a little behind the curve, certainly with respect to US banks.
Cdubey - 5 years ago    Report SPAM
@Vgm By suffering I meant only the share price, not the business itself. BAC has fallen 15% so far. JPM, C and BAC fell more than 3% each on friday. I was not commenting on the business itself.

I don't have anyway to judge how clean the banks are, compared to the past. Verifiably, the leverage has gone down a lot. Buffett thinks that they are much cleaner and I have no reason to doubt him. But I accept my lack of ability in verifying it for myself. As long as I cannot do it myself, the investment will still be speculating from my part.

The point of this series of articles is not to compare STD and WFC or for that matter, any two banks. I am trying to develop a framework and things to look for before investing in a bank. As you see that this is very different from how you will try to value/understand a regular business.

I am very far behind the curve, even for European banks. This is what I am trying to fix.

Cdubey - 5 years ago    Report SPAM
@Bel-Air: I am happy that you found the articles helpful.

Sadly, I find myself lacking in judging a bank yet. I am still trying to understand different moving pieces and it will take a bit more time for me to be comfortable in venturing an opinion.

I would not feel comfortable in giving you an opinion yet.
Vgm - 5 years ago    Report SPAM

Thanks. I applaud and admire your determination to build a framework for understanding. Arguably banks are a challenging place to start, however. Three of the "cleanest" and safest of the large US banks are probably Wells, JPM, and USB, but because of that they may not offer the upside potential of a BAC or Citigroup.

No need to see the short term price declines as "suffering" - they are positives if they offer us a better entry point. Yes, BAC is down a bit of late - but is up ALOT since December and to me still has a considerable way to run.

As I'm sure you're aware, Jamie Dimon's letters to shareholders, as recommended by Buffett, are an excellent education about banks in general.

Good luck!

Disclosure: long BAC, C
Praveen Chawla
Praveen Chawla premium member - 5 years ago
I am looking seriously at Banco Santander. It is supposedly the strongest bank in Spain with more than half its business outside Spain. Its capital ratio's are strong but much of its core capital are sovereign Spanish bonds - which are currently under great pressure. If spain does not default the shares could easily quadruple from here - but if it does- its could collapse to a fourth or more from here.
Cdubey - 5 years ago    Report SPAM
STD has less spanish debt compared to a year earlier. But they still own $50B in spanish debt, as far as I recall. There were some excellent articles by Jim Jubak (see here and here).

@Vgm Thank you for the shareholder letter recommendation. I knew about them but never got around to reading them. I will now.
Vgm - 5 years ago    Report SPAM

STD is thought to be the strongest bank in Spain, with some 75% of revenues coming from outside the Iberian peninsula - mainly S America.

If you're looking at European banks, have you considered Bank of Ireland? There's been alot written about it on GuruFocus. As you may know, the big pull is that Wilbur Ross and Prem Watsa have taken major stakes a year or so ago, essentially bailing out the Irish government.

They paid around 10 euro cents per share with book value about 30. Not surprisingly, it's been very volatile but is back around the 10 cent mark. It's not often we get the opportunity to get in alongside two of the world's most intelligent investors at a similar, or even lower, price.

Ross and Watsa have both described it as a long term play (5 years). Ireland, as different from the ClubMed countries, is emerging strongly from the recession and has excellent prospects. Ross has talked about Ireland frequently - video links will also be found here on GuruFocus.

There's an ADR (IRE) on the NYSE and it trades as BKIR in London, and BIR in Dublin.

Disclosure: long BKIR
Ilovesummer - 5 years ago    Report SPAM
How can you evaluate them accurately when the ratings services, banks and govt were calling

sub prime AAA. What has changed on that front? Did anyone on top go to jail for blatant fraud or

payback their ill gotten wages.

Leahman brothers CEO Dick Fuld was assuring me and other shareholders that everything was OK

days before the collapsed. Where was that info in print that they were on the verge of collapse.

The only small bit of reassurance is that maybe after all this exposure is that maybe they will

behave for a while , tthen probably come up with a new trick that will fill their pockets and screw investors.

Cdubey - 5 years ago    Report SPAM
@llovesummer Very true. Stick with a management that is good. Like WFC. If the management is honest, you might have a better chance.

You don't have to invest in banks. There are perfectly reasonable or even better investments outside this sector. Increasing your knowledge on the other hand is always helpful.

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