Financial Analysis of Banking Institutions

Financial Analysis of Financial Institutions

1. One example: http://www.fool.com/investing/general/2014/04/29/how-i-analyze-a-bank-stock.aspx

How I Analyze a Bank Stock – The Motley Fool

At their core, each bank borrows money at one interest rate and then lends it out at a
higher interest rate, pocketing the spread between the two.

Focusing on four tenets:

• What the bank actually does
• Its price
• Its earnings power
• The amount of risk it’s taking to achieve that earnings power

Read Balance sheet:

• Loans are the heart of a traditional bank. In my mind, the greater a bank’s loans as a percentage of assets, the closer it is to a prototypical bank.
• what types of loans a bank makes – prefer majority of loans are business-related (commercial) as opposed to mortgage loans (though other forms of collateral may be in play)
• Just as the loans tell the story on the assets side, the deposits tell the story on the liabilities side. The prototypical bank takes in deposits and makes loans, so two ratios help get a feel for how prototypical your bank is: 1) Deposits/Liabilities 2) Loans/Deposits.
• If a bank can’t attract a lot of deposits, it has to take on debt (or issue stock on the equity side), which is generally much more expensive. That can lead to risky lending behavior i.e. chasing yields to justify the costs.
• Application: Fifth Third’s deposit/liabilities ratio is 86%, which is quite reasonable and leads to an equally reasonable 89% loan/deposit ratio. All of this confirms what we suspected after looking at the loans on the asset side. Fifth Third is a bank that, at its core, takes in deposits and gives out loans with those deposits. If that wasn’t the case, we’d want to get comfortable with exactly what it’s doing instead.

Read Income Statement:

• The big thing to focus on here is the two different types of bank income: net interest income and noninterest income.
• a bank makes money by borrowing at one rate (via deposits and debt) and lending at another higher rate (via loans and securities). Well, net interest income measures that profit.
• noninterest income is the money the bank makes from everything else, such as
  fees on mortgages, fees and penalties on credit cards, charges on checking and savings
  accounts, and fees on services like investment advice for individuals and corporate banking for businesses.
• Application: For Fifth Third, it gets almost as much income via noninterest means ($3.2 billion) as it does from interest ($3.3 billion). Like most of what we’ve covered so far, that’s not necessarily good or bad. It furthers our understanding of Fifth Third’s business model. For instance, the noninterest income can smooth interest rate volatility but it can also be a risk if regulators change the rules (e.g. banks can no longer automatically opt you in to overdraft protection…meaning they get less of those annoying but lucrative overdraft fees).

Price:

• The oversimplified saying in banking is “buy at half of book value, sell at two times book value.” Just as if I told you to “buy a stock if its P/E ratio is below 10, sell if it’s over 25” there are many nuanced pitfalls here, but it at least points you in the right direction.
• Application: In Fifth Third’s case, it currently has a price-to-book value of 1.3 and a price-to-tangible book value of 1.5. In today’s market that’s a slight premium to the median bank. Like any company, the reason you’d be willing to pay more for one bank than another is if you think its earning power is greater, more growthy, and less risky.
  Our first clue on Fifth Third’s earnings power is also our last valuation metric: P/E ratio. Fifth Third’s clocks in at just 10.7 times earnings. That’s lower than its peers. In other words, although we’re paying an above average amount for its book value, we’re seeing that it’s able to turn its equity into quite a bit of earnings.

Earnings power:

• I talked a bit about how Fifth Third has a lower than average P/E ratio despite having a
  higherthanaverage P/B ratio. The metric that bridges that gap is called return on equity
  (ROE). Put another way, return on equity shows you how well a bank turns its equity into earnings. Equity’s ultimately not very useful if it can’t be used to make earnings.
  Over the long term, an ROE of 10% is solid. Currently, Fifth Third is at 12.3%, which is quite good on both a relative and absolute basis.
• net interest margin: measures how profitably a bank is making investments. It takes the interest a bank makes on its loans and securities, subtracts out the interest it pays on deposits and debt, and divides it all over the value of those loans and securities. In general, it’s notable if a bank’s net interest margin is below 3% (not good) or above 4% (quite good). Fifth Third is at 3.3%, which is currently higher than some good banks, lower than others.
• efficiency ratio: takes the noninterest expenses (salaries, building costs, technology,
  etc.) and divides them into revenue. So, the lower the better. A reading below 50% is the gold standard. A reading above 70% could be cause for concern. Fifth Third is at a good 58%.
• Meanwhile, ROE and net interest margins can be juiced by taking more risk.

Risk

• Fed does its annual stress test of the largest banks, it looks at these five: Tier 1 common ratio;  Common equity tier 1 ratio; Tier 1 risk-based capital ratio; Total risk-based capital ratio; Tier 1 leverage ratio.
• I rely on a much simpler ratio: assets/equity
• When you buy a house using a 20% down payment (that’s your equity), your assets/equity ratio is at five (your house’s value divided by your down payment).
  For a bank, I get comfort from a ratio that’s at 10 or lower. My worry increases the farther above 10 we go. Fifth Third’s is at a reasonable 8.7 after its most recent quarter (8.9 if you’re doing the math on the year end balance sheet above).
• That leverage ratio gives us a good high level footing. Getting deeper into assessing
  assets, we need to look at the strength of the loans. Let’s focus on two metrics for this: Bad loan percentage (Nonperforming Loans/Total Loans); Coverage of bad loans (Allowance for nonperforming loans/Nonperforming loans).
• I use dividends as an additional comfort point.

Summary

Because most banks share similar business models, the numbers will go a long way to help
you determine if those stories hold water. If a bank says it’s a conservative lender, but half of its loans are construction loans, it has a 10% bad debt ratio, and it’s leveraged 20:1, I’m trusting the numbers not the words. Look at the numbers over the last decade or two and you’ll see many clues. When a bank has been able to deliver large returns across a few economic cycles while keeping the same general business model, that’s a very good thing. Even better if the same management team has been there the whole time or if the bank clearly has a conservative culture in place that stays in place between management teams.

2. Fron Investpedia

http://www.investopedia.com/articles/stocks/07/bankfinancials.asp

Analyzing A Bank _ Investopedia

Financial statements for banks present a different analytical problem than statements for manufacturing and service companies. As a result, analysis of a bank’s financial statements requires a distinct approach that recognizes a bank’s unique risks.

Banks take deposits from savers and pay interest on some of these accounts. They pass these funds on to borrowers and receive interest on the loans. Their profits are derived from the spread between the rate they pay for funds and the rate they receive from borrowers. This ability to pool deposits from many sources that can be lent to many different borrowers creates the flow of funds inherent in the banking system. By managing this flow of funds, banks generate profits, acting as the intermediary of interest paid and interest received, and taking on the risks of offering credit.

Leverage and Risk
Banking is a highly leveraged business requiring regulators to dictate minimal capital levels to help ensure the solvency of each bank and the banking system. In the U.S., a bank’s primary regulator could be the Federal Reserve Board, the Office of the Comptroller of the Currency, the Office of Thrift Supervision or any one of 50 state regulatory bodies, depending on the charter of the bank. Within the Federal Reserve Board, there are 12 districts with 12 different regulatory staffing groups. These regulators focus on compliance with certain requirements, restrictions and guidelines, aiming to uphold the soundness and integrity of the banking system.

As one of the most highly regulated banking industries in the world, investors have some level of assurance in the soundness of the banking system. As a result, investors can focus most of their efforts on how a bank will perform in different economic environments.

Below is a sample income statement and balance sheet for a large bank. The first thing to notice is that the line items in the statements are not the same as your typical manufacturing or service firm. Instead, there are entries that represent interest earned or expensed, as well as deposits and loans.

Figure 1: The Income Statement

Figure 2: The Balance Sheet
As financial intermediaries, banks assume two primary types of risk as they manage the flow of money through their business. Interest rate risk is the management of the spread between interest paid on deposits and received on loans over time. Credit risk is the likelihood that a borrower will default on a loan or lease, causing the bank to lose any potential interest earned as well as the principal that was loaned to the borrower. As investors, these are the primary elements that need to be understood when analyzing a bank’s financial statement.

Interest Rate Risk
The primary business of a bank is managing the spread between deposits (liabilities, loans and assets). Basically, when the interest that a bank earns from loans is greater than the interest it must pay on deposits, it generates a positive interest spread or net interest income. The size of this spread is a major determinant of the profit generated by a bank. This interest rate risk is primarily determined by the shape of the yield curve.

As a result, net interest income will vary, due to differences in the timing of accrual changes and changing rate and yield curve relationships. Changes in the general level of market interest rates also may cause changes in the volume and mix of a bank’s balance sheet products. For example, when economic activity continues to expand while interest rates are rising, commercial loan demand may increase while residential mortgage loan growth and prepayments slow.

Banks, in the normal course of business, assume financial risk by making loans at interest rates that differ from rates paid on deposits. Deposits often have shorter maturities than loans and adjust to current market rates faster than loans. The result is a balance sheet mismatch between assets (loans) and liabilities (deposits). An upward sloping yield curve is favorable to a bank as the bulk of its deposits are short term and their loans are longer term. This mismatch of maturities generates the net interest revenue banks enjoy. When the yield curve flattens, this mismatch causes net interest revenue to diminish.

A Banking Balance Sheet
The table below ties together the bank’s balance sheet with the income statement and displays the yield generated from earning assets and interest bearing deposits. Most banks provide this type of table in their annual reports. The following table represents the same bank as in the previous examples:

Figure 3: Average Balance and Interest Rates
First of all, the balance sheet is an average balance for the line item, rather than the balance at the end of the period. Average balances provide a better analytical framework to help understand the bank’s financial performance. Notice that for each average balance item there is a corresponding interest-related income, or expense item, and the average yield for the time period. It also demonstrates the impact that a flattening yield curve can have on a bank’s net interest income.

The best place to start is with the net interest income line item. The bank experienced lower net interest income even though it had grown average balances. To help understand how this occurred, look at the yield achieved on total earning assets. For the current period, it is actually higher than the prior period. Then examine the yield on the interest-bearing assets. It is substantially higher in the current period, causing higher interest-generating expenses. This discrepancy in the performance of the bank is due to the flattening of the yield curve.

As the yield curve flattens, the interest rate that the bank pays on shorter-term deposits tends to increase faster than the rates it can earn from its loans. This causes the net interest income line to narrow, as shown above. One way banks try to overcome the impact of the flattening of the yield curve is to increase the fees they charge for services. As these fees become a larger portion of the bank’s income, it becomes less dependent on net interest income to drive earnings.

Changes in the general level of interest rates may affect the volume of certain types of banking activities that generate fee-related income. For example, the volume of residential mortgage loan originations typically declines as interest rates rise, resulting in lower originating fees. In contrast, mortgage-servicing pools often face slower prepayments when rates are rising, since borrowers are less likely to refinance. As a result, fee income and associated economic value arising from mortgage servicing-related businesses may increase or remain stable in periods of moderately rising interest rates.

When analyzing a bank, you should also consider how interest rate risk might act jointly with other risks facing the bank. For example, in a rising rate environment, loan customers may not be able to meet interest payments because of the increase in the size of the payment or a reduction in earnings. The result will be a higher level of problem loans. An increase in interest rates exposes a bank with a significant concentration in adjustable rate loans to credit risk. For a bank that is predominately funded with short-term liabilities, a rise in rates may decrease net interest income at the same time that credit quality problems are on the rise.

Credit Risk
Credit risk is most simply defined as the potential of a bank borrower or counterparty to fail in meeting its obligations in accordance with agreed terms. When this happens, the bank will experience a loss of some or all of the credit it provided to its customer. To absorb these losses, banks maintain an allowance for loan and lease losses.

In essence, this allowance can be viewed as a pool of capital specifically set aside to absorb estimated loan losses. This allowance should be maintained at a level that is adequate to absorb the estimated amount of probable losses in the institution’s loan portfolio.

Actual losses are written off from the balance sheet account “allowance” for loan and lease losses. The allowance for loan and lease losses is replenished through the income statement line item “provision” for loan losses. Figure 4 shows how this calculation is performed for the bank being analyzed.

Figure 4: Loan Losses
Investors should consider a couple points from Figure 4. First, the actual write-offs were more than the amount management included in the provision for loan losses. While this in itself isn’t necessarily a problem, it is suspect because the flattening of the yield curve has likely caused a slowdown in the economy and put pressure on marginal borrowers.

Arriving at the provision for loan losses involves a high degree of judgment, representing management’s best evaluation of the appropriate loss to reserve. Because it is a management judgment, the provision for loan losses can be used to manage a bank’s earnings. Looking at the income statement for this bank shows that it had lower net income due primarily to the higher interest paid on interest-bearing liabilities. The increase in the provision for loan losses was 1.8%, while actual loan losses were significantly higher. Had the bank’s management just matched its actual losses, it would have had a net income that was $983 less (or $1,772).

An investor should be concerned that this bank is not reserving sufficient capital to cover its future loan and lease losses. It also seems that this bank is trying to manage its net income. Substantially higher loan and lease losses would decrease its loan and lease reserve account to the point where this bank would have to increase the future provision for loan losses on the income statement. This could cause the bank to report a loss in income. In addition, regulators could place the bank on a watch list and possibly require that it take further corrective action, such as issuing additional capital. Neither of these situations benefits investors.

The Bottom Line
A careful review of a bank’s financial statements can highlight the key factors that should be considered before making a trading or investing decision. Investors need to have a good understanding of the business cycle and the yield curve – both have a major impact on the economic performance of banks. Interest rate risk and credit risk are the primary factors to consider as a bank’s financial performance follows the yield curve.

When it flattens or becomes inverted, a bank’s net interest revenue is put under greater pressure. When the yield curve returns to a more traditional shape, a bank’s net interest revenue usually improves. Credit risk can be the largest contributor to the negative performance of a bank, even causing it to lose money. In addition, management of credit risk is a subjective process that can be manipulated in the short term. Investors in banks need to be aware of these factors before they commit their capital.
Read more: Analyzing A Bank’s Financial Statements | Investopedia http://www.investopedia.com/articles/stocks/07/bankfinancials.asp#ixzz4EuvbA9b6
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2. Fundamentals of Bank Financial Statement Analysis