Sunday, 11 March 2018

Education Series - Sector Analysis: Metrics to Analyse Banks

The trio of local banks - DBS, OCBC and UOB, are major components of Singapore's economy. Not only are they the biggest market-capitalisation companies in the stock market, occupying the largest weightage in the Straits Times Index, the three local banks are also among the safest banks in the world. Global Finance ranked DBS, OCBC and UOB among the world's top 15 safest banks in 2017.

Banks have large asset base, comprising of deposits, loans and assets under management. Being in the heavily-regulated financial industry with many liquidity, credit risk and interest risk requirements, their financial statements can be complicated to analyse, peppered with financial jargon.

So in this article, I would like to share 5 metrics that I usually look at while analysing banks. These are important numbers particularly relevant to the banking industry that provides good indication of a bank's strength and operation efficiency.

Firstly, let's understand what banks do first.

The business of banking - in layman's term
Banks serve as a funnel of the capital creation process, and a conduit that matches the supply of funds to entities that demand funds. Its nature of business, fundamentally, is to gather funds from depositors and lend them out to individuals or corporations to fund various productive activities. In the process, banks earn a spread between interest that they pay, and interest that they charge.

Stemming from the basic deposit-taking and loan-issuing functions are other related services such as wealth management and advisory, investment banking, brokerage services, corporate consultancy etc.

So what are the 5 metrics that I look at?

Net Interest Margin (NIM)
Banks pay interest to depositors' for their funds parked with the bank, which is then lent out as housing loans, car loans, and corporate loans. Debtors would then pay interest to the bank.

The difference between the interest that banks pay and interest received, represent a big chunk of banks' profit. This is the net interest. Taken in relation to the total assets as a percentage, this represent the NIM.

Essentially, NIM measures the profitability of a bank. The higher percentage, the better.

Cost-Income Ratio
Also known as Expense Income Ratio. This indicator tells you how efficiently a bank is managed. A lower ratio means costs are being kept in check. For this ratio, the lower the better. To get this metric, divide the operating costs by operating income.

Return on Equity
ROE is an important gauge of bank's profitability based on company's equity - whats truly belong to shareholders after striping off the debts. A higher percentage means the bank is more effective in utilising shareholders' funds in earning a profit.

However, one needs to note that an exceptionally high ROE could be deceptive due to large proportion of debts in a bank's assets (as Assets = Debts + Equity. Large debt means small equity, boosting the ROE figure), and banks with much debts could be risky during period of rising interest rate or inflation. Hence we need to check what is the level of debts in the bank.

Leverage Ratio
Earlier I mentioned that banks are subjected to strong capital adequacy requirements and regulatory governance. One such global requirement is the Basel lll, a global regulatory framework that stipulates a minimum 3% Leverage Ratio. Short of going into the details which can be boring, Leverage Ratio is defined as the Tier 1 Capital over the bank's average total consolidated assets.

So do note that some banks can have a very high ROE and Leverage too. Then this is not a good sign as it could mean that the bank is chasing high returns fueled by high debts.

Non Performing Loan (NPL) Ratio
NPL is the sum lent out which the debtor has not made his interest payment or scheduled payment for 90 days. These loans are at a higher risk of becoming bad debts and written off. Then the bank's earnings could be affected. Percentage of NPL in the bank's total loan book is the NPL ratio.

A Snapshot of Local Banks Metrics
I compiled the above metrics for the three local banks based on their FY17 earnings for your reference.

It seems that OCBC stands out among the 3, based on these 5 metrics alone. Before you jump into buying bank shares, please do further due diligence to study each bank's prospects, growth strategy, and past performance especially during economic downturn etc to determine if they truly suit your investment style and portfolio risks.

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