• Log in

Thicken My Wallet

Everything to do with thickening your wallet

• Home

Why are some banks doing better than others?

Posted by admin on June 1, 2009 in Investment Information

With most of the large North American banks reporting their last financial quarter’s results (a quick and dirty summary of Canadian banks and insurance company financial reports can be found here), and the dust settling somewhat on the financial sector as a whole (emphasis on “somewhat”), market analysts are beginning to pick winners and losers for the short to medium term.  What seems to be emerging as one of the factors anointing a market darling vs. a dud is, well, a bank acting like a bank.

There appears to be a renewed emphasis on which bank has the best retail operations and is best at attracting our money. After all, with the IPO market mostly dried up and the increased risks of wholesale banking, retail banking is a safe means to generate profit, especially in light of increased savings rates, and recapitalize many financial institutions.

Thus, TD Bank, which is now one of the largest banks in North America by market cap, is perceived to trade at a premium given its strong retail operations (Canadian Personal and Commercial Banking revenue up 7%, earnings up 1% in the last quarter from the same quarter as last year to off-set a 8% loss in U.S. Personal operations). Conversely, CitiBank, who’s Consumer Banking division revenue declined 18% in the last quarter is seem by some as the most vulnerable of the large American banks (just as a methodology note, the retail divisions of banks are all arranged differently so there is not a strict apples to apples comparison which can be made, adding to the fact financial assumptions are different bank to bank).

However, pure deposit growth alone does not anoint one a market darling. There has been a return to the fundamentals in banking analysis with a renewed look at loan-to-deposit ratios (LDR). A LDR is a ratio dividing a bank’s loans to its deposits at any point in time. The lower the LDR, the more liquid a bank will be given its money is not all tied up in loans. A LDR over 100% means that a bank is actually borrowing money to meet its withdrawal obligations given it has lent out all of its deposits and more.

Conventionally,  an ideal LDR was quite conservative (approximately 50% of deposits went out in loans and 50% invested in treasuries or other safe fixed income instruments) but had been creeping up decade after decade. When off-balance sheet transactions (i.e. securitizations like ABCP) began to occur in scale in tandem with cheap sources of capital, there was a certain school of thought that LDR did not matter anymore since risk could allocated to third parties to reduce the ratio and you could always borrow more to get out of trouble.

Thus, LDR broke 100% and peaked at 113% in 2007 according to FDIC (in plain English, a bank took 100 cents of every $1 deposited and lent it out then borrowed the other 13% and lent that out). Citibank has recently been quoted as estimating LDR for the big four American banks (Citibank, JPMorgan Chase, Wells Fargo and Bank of America) at 153%, the UK banks at 144% and the Canadian banks at 74%.

Thus, a growth of the retail deposit base is, in and of itself, not solely determinative of a bank’s short to medium term future. Markets are punishing banks who, even with a strong retail base, have high LDR. For example, Wells Fargo, often cited as having one of the stronger retail operations, had some analysts downgrade the bank’s stock rating after reporting mostly positive quarterly results due partially to a LDR of 103% .

Thus, the analysis is not only on how well a bank is increasing its deposit base but what it is doing with the money. If a substantial part of the deposit base is being used to decrease LDR to something more tolerable, the bank will not get the same market reaction as a bank with an acceptable LDR increasing its deposit base.

High LDR’s also explain why banks are being recapitalized but the money is not being lent out at the same pace.  Banks could simply be utilizing deposits to buy treasuries to lower the LDR. The banks over-lent and now have to under-lend to bring balance back in their balance sheets.

As to whether there is a banking stock rebound soon… I don’t know. There’s still two possible shoes to fall- what happens if credit card default rates reach critical mass and corporate loan default rates spike? Can poorly-capitalized banks withstand those challenges?

Notwithstanding my non-prediction, if banks begin to behave like banks again, it is not a stock you need to market-time (as a retail investor, you shouldn’t market time anything). When the dust settles, a bank paying a steady dividend combined with appreciation at inflation plus should keep most investors happy.

Disclosure: I own TD.