Evaluating Banks
The banking sector is something special, with its core product being money. Banks take deposits and redistribute them through credits. Evaluating banks is a lot more difficult than traditional goods based industries. But a ton of money goes through it, so is certainly worth taking a closer look. Uncle Stock has recently added the some extra ratios that target the banking industry, also a custom bank view has been created. The purpose of this article is to give an explanation for the most important bank ratios available on Uncle Stock. You can find these ratios under the bank view, as shown on the screenshot below. I have divided the ratios into two categories: efficiency and risk.
Efficiency
A first category of ratios measures bank efficiency. Efficiency measures how good a bank is in turning received assets into profit. For efficiency the following ratios are discussed: ROA, ROE, Cost/income and net interest margin over earning assets.
Return On Assets And Return On Equity
The first ratios that are very important when evaluating banks are ROA (return on assets) and ROE (return on equity). These ratios are used widely over different industries to determine the profitability or effective use of a company’s resources. But especially for banks they are useful, as cash flow models are difficult to apply on banks. The higher ROA and ROE, the better.
Cost To Income
A second widely used ratio for bank efficiency is the Cost to Income ratio. Cost to Income measures how much costs a bank makes relatively to its income. It should be as low as possible. If this ratio is declining, a bank is becoming more efficient. A recent trend to improve this Cost to Income is reducing costs by closing regional offices and allocating clients towards a central office. If a bank manages to keep the same clients afterwards, this ratio drops as efficiency has improved. Because of the increasing popularity of web applications, that is possible to achieve.
Net Income Over Earning Assets
The last ratio that measures efficiency is net interest income over interest earning assets. Interest earning assets are all the assets that can increase interest earnings. This ratio is so important, as it shows how profitable a bank is in its core activity: earning interests. This ratio is historically usually around 3- 4 percent, but it is very interest rate sensitive. When interest rates are very low and especially when they stay low for a decent amount of time, interest margins get squeezed and this makes it very hard for banks to reach that historical averages nowadays. For example on the screenshot below, you can see the NII/TA for ING declining over the past couple of years.
Risk
A company can improve itself by improving efficiency, but one can only speak of true improvement if efficiency improves without taking more risk. Banks can improve their profits by increased risk, but this is not sustainable. There are many ways to measure bank risk, I will discuss two that are included in the Uncle Stock bank view: Equity Ratio and LTD (Loans to Deposits ) ratio.
Equity Over Total Assets
The Equity ratio helps evaluating banks through its leverage, being a more general way of measuring capital risk. If a bank has a high proportion of equity over total assets, it will be more robust to temporary recessions as there is no fixed term on paying back equity. So a low value implies less risk. As banks make a lot of their profits through leverage, it is normal that this ratio is lower than for other industries.
Loans To Deposits
The LTD ratio is very bank specific as the core activity of a retail bank is transferring deposits into loans. This ratio is important because if loans are covered by underlying deposits, they are more save. Outside borrowing is at a higher cost and could reduce the trust of the deposit holders which will become more likely to remove their deposits in a crisis. This causes a liquidity risk.
It is also possible on Uncle Stock to get more advanced dimensions on these ratios such as growth and standard deviation:
Screening
I hope this post gives some insights in evaluating banks using Uncle Stock. In 1-2 months the data from the new ratios is expected to be populated in the Uncle Stock database and it will be possible to use the new ratios for screening and back testing. Hereafter, I am planning to do another post about banks focusing on screening and back testing.
