Evaluating Banks



Equity/asset ratios, net interest margins, efficiency ratios, charge - off ratios — all of these figures and more will influence a bank ’ s profitability. These profits, in turn, dictate the security of a bank ’ s dividend and its ability to grow. Every bank is different (even though many will look more or less the same at first glance). Strategies vary widely — some focus on commercial lending, others on consumers, still others on residential real estate, specialty finance, or investment banking. A few even cling to the old thrift business model (also known as a savings and loan) and use depositors ’ funds to buy long - term mortgages.
Whatever the strategy, it might amaze you that banks that are merely average routinely earn ROEs of 15 percent or more. After all, money is probably the ultimate commodity. But if money is a commodity, it also never goes out of style, as Christopher Davis of Davis Advisors — a champion investor in financial services firms — has pointed out. Loans and deposits aren ’ t subject to technological changes; sure, individual lenders or deposit takers can tweak the terms and rates offered on such products, but the basic function of these activities is timeless and utterly essential to the functioning of a capitalist economy.
The economic moats that banks use to earn these handsome returns come from a variety of sources.
Regulation . Many industries are regulated by various levels of government; for example, utility regulators routinely step in to limit profits to prevent monopoly abuse. Banks are heavily regulated too, but there ’ s no ham - handed ceiling on profits. Instead, regulators pay close attention to the health of a bank ’ s balance sheet. Since the Federal Deposit Insurance
Corporation (FDIC) guarantees depositors ’ funds up to $ 100,000 apiece, the chief goal of bank overseers is to ensure that no deposit - taking institution goes bust. Regulators have a great deal of power to limit or stop what they might view as risky lending practices (risks that might jeopardize depositors ’ dollars), and they inadvertently shield the bank ’ s stockholders from loss as well. It ’ s no small wonder, then, that bank failures are very rare. In 1997 – 2006, only 44 banks failed in the United States out of the 10,000 - plus that were in existence.
Many banks are too big to fail. If Bank of America (BAC), Citigroup (C), or JPMorgan Chase (JPM) — which are literally trillion - dollar institutions — or even one of the larger regional banks were to go belly - up, the repercussions through the rest of the financial system would be catastrophic. Regulators will step in long before such an event threatens the economy.
This doesn ’ t mean that regulators are always friendly to banks. In 2006, the Federal Reserve raised short - term interest rates to a level that made banks ’ holdings of Treasury bonds structurally unprofitable, an environment that in turn led bank profit growth to slow to a crawl. Even so, returns on equity remained in that 15 to 20 percent range across the board.
Cheap funding . The fact that the government guarantees deposits, plus the fact that checking deposits by tradition pay very little interest (if any), allows banks to fund their loans and other earning assets more cheaply than any other player in the economy. In early 2007, a time when the U.S. Treasury had to pay 5 percent to borrow short - term and 4.5 percent or more on long - term bonds, banks ’ average cost of funds was less than 4 percent. Making good returns on lending can be a tough business; anyone can make a loan, but only a bank can take a deposit.
Customer switching costs . When passing a new bank branch in your neighborhood that offers a $ 100 bonus on new checking accounts, do you jerk the steering wheel to the right, march on in, and transfer your accounts on the spot? Of course not. Chances are you, like tens of millions of your fellow Americans, have your paychecks wired into your existing checking account, your mortgage and car payments automatically wired out, and