Banks traditionally make money by accepting deposits, and lending the money out at a higher rate of interest charged than the interest being provided on the deposit. The deposits and lending may have individuals or institutions as their counterparties, with the margins smaller for institutions; but costs being lower as a percentage of the business and expected defaults also being lower.
If deposits are insufficient, then banks may borrow money on financial markets to fund their lending.
Retail banking requires building and maintaining a significant infrastructure of ATMs, internet banking and credit cards. The fees from these are lucrative - account fees, ATM fees, penalty charges if you miss a payment, applications fees for loans. Retail clients are relatively "sticky", it's a mission to change banks.
They may also offer:
Investment banks may assist companies with:
Raising finance, via debt or issuing equity.
Finding buyers for part of or a whole company.
Mergers & acquisitions and other corporate events.
Projecting Cashflows
Are there areas in which competitors are outcompeting the bank and is this likely to continue? Will protecting its market result in poorer margins for the bank?
What areas is the bank targgetting for growth, what are the chances of success, what margins and volumes are likely, and will it impact on margins for existing business?
What are the likely future expenses of the bank - for example IT infrastructure and physical infrastructure. Does the bank, e.g., plan on reducing the number of physical branches, and would is the likely impact on business volumes? How much will the bank have to spend on preventing and insuring against the threats of hacking of client accounts and other forms of cyber-terrorism.
What impact are future regulations likely to have on the business, e.g. on future volumes, expenses and margins.
Risk Discount Rate
To value a bank you need to discount its projected future cashflows at an appropriate rate, known as the risk discount rate. If the future cashflows have a higher range of uncertainty, then they should be discounted at a higher rate to compensate for the additional risk being taken on. There are numerous risks which threaten the solvency, liquidity and future growth of banks. Shareholders should acquire an understanding of the risks being taken on, the exposure to them, and the range of outcomes they could result in.
It is important to assess management of the bank, to get a feel for how well managed these risks are.
Diversification of income sources
Being diversified across the various income sources mentioned above decreases risk: lending, deposits, transaction fees, unit trusts, brokerage services, trust services assisting with raising finance and advising on corporate events. What level of geographical diversification is there?
Diversification and cost of funding
How diversified are the bank's sources of fund (e.g. deposits, borrowing from particular counterparties,...)?
Default risk
Default risk on amounts lent is one of the primary risks faced by banks, and is the risk that borrowers can't (or wont) repay the amounts owed. Default risk is also known as credit risk; and can be divided into:
The bank will, in setting interest rates for customers, allow for a certain percentage of defaults, and the real risk is that the number of defaults is higher than those expected. Defaults could be due to poor underwriting, or due to unpredictable events. It's important that banks closely monitor and manage default risk. One can get a feel for a bank's default risk by looking at:
Split of lending across types of lending; e.g on home loans, loans on credit, vehicles, credit cards, unsecured loans, etc.. (diversification reduces risk).
Split of lending by duration.
Split of lending across individuals working in different industries and with different levels of income.
The level of and quality of collateral.
It's critically important that the level of provisioning for defaults is sufficient. As the level of default varies through the cycle, when in the low default part of the cycle banks may be tempted to provide for the new lower default rates, not recognising that the this will be insufficient when the cycle changes. Provisioning should look through the cycle of default rates. Investigating this will entail examining how provisioning levels have changed over time and how they compare against competitors (both currently and historically). Special attention should be placed on the most recent levels of defaults.
Balance sheet strength
The strength of a bank's balance sheet refers to the capital reserves available for further expansion, and how much bad news it can withstand before breaching covenants on its own debt or running into regulatory difficulties. Have a look at how and why the capital reserves have changed over time. Investigate how the bank's capital is invested. Investing cautiously will result in lower returns, but also lower the likelihood of falls in values of the capital threatening the bank's solvency.
Liquidity
How liquid are the bank's assets? How readily available are they if there's a run on the bank? It wont help if there's plenty of capital if it can't be accessed; but alongside the liquidity of assets assess the bank's credit facilities.
Operational risk
Operational risks: breakdown in internal controls (e.g. enforcing compliance with limits for borrowing to individual counterparties), failure of IT systems (banks are becoming increasingly reliant on IT infrastructure), fraud, security (including hacking and cyber-terrorism) and model risk (internal models procuding inaccurate results). Operational risk may sometimes be complicated by the operations being outsourced.
Market risk
Adverse market movements in the markets can have several negative repercussions for banks:
Banks may have investments in equities, bonds, currencies and/or even commodities. The value of these assets may fall.
Underperformance of collective investment schemes.
Interest rate risk is a critical subset of market risk, related to changes in interest rates; most banks are more exposed to decreases in interest base rates; because of having more assets invested short-term. Interest rate risk is exacerbated by any mismatch of assets & liabilities by term or nature - fixed vs floating. Special attention should be paid to the level of matching and hedging activities which the bank has undertaken, and what the remnant naked positions are.
Reinvestment risk is the risk of borrowers paying their loan amounts back earlier than anticipated, and insufficient returns earned on reloaning or reinvesting the proceeds. Reinvestment risk is exacerbated by pre-payment risk.
Investigate what models the bank uses for monitoring and managing market risk, e.g. Value at Risk models; consider how good the model is, what the limits are, and the assumptions underlying the model. What stress tests does the bank subject its accounts to, in terms of market movements, and what are the results?
Liquidity risk
The risk of having insufficient cash to make payments as they fall due (liquidity risk, often caused by mass withdrawal of deposits - a "run on the bank" when depositors lose faith in the bank). A typical banks assets are relatively long term (e.g. mortgages), whilst the liabilities are short-term (e.g. deposits), so assets can't be unwound as easily as liabilities. The bank may then need to borrow money at a higher rate than it was earning on its deposits, or sell assets potentially at prices below their market value.
Reputational risk
What negative press has the bank had over the last few years? Has the bank developed a bad reputation in any areas? For example, that it is expensive. Is this bad reputation already reflected in poor performance or is performance likely to deteriorate further? Is the bad reputation counterbalanced (e.g. high fees but better service).
Regulatory risk
Expense risk
Banks normally have enough control over their expenses, especially relative to each other, and being able to increase charges in response to them, that the risk of high expenses is relatively small. Expenses include spend on physical and IT infrastucture.
Disaster Recovery
Should a disaster strike, e.g. a bomb or massive cyber-terrorism even, what is the ability of the bank to recover.
Legal Risk
What legal cases is the bank involved in?
Warren Buffett
"A bank that earns 1.3 or 1.4% on assets is going to end up selling above tangible book value. If it's earnings 0.6 or 0.5% it's not going to end up selling above tangible book value. Book value is not key to valuing banks. Earnings are key to valuing banks, and you earn on assets. Now it translates to book value to some extent because you are are required a certain amount of tangible equity compared to the assets that you have. You've got banks like Well Fargo & USB that earn very high return on assets and they sell at a good price to tangible book. You've got other banks like the 2 you mentioned that are earning lower returns on tangible assets and they're going to sell below book." Warren Buffett
http://data.worldbank.org/indicator/FB.BNK.CAPA.ZS
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