Sunday, June 29, 2008

Bank stocks - The Business of Banking, and Investing in Banks

We have recently seen many big-name banks declaring huge losses and raising capital from investors. They look like they are tip-toeing through a credit minefield, and stepping on a mine every few weeks as their portfolio of loans and assets deteriorate and new credit exposures surface. Is this the nature of the banking industry? Are banks just one of those lousy businesses that investors should stay away from?

Not in my opinion.

At its core, the business of banking is the business of (1) attracting customers and (2) managing risks.

Credit Risk Management
Banks, both investment banks and commercial banks, borrow money from one group of people and lend it to another group of people. They make money when the people they lend to are credit worthy, and lose money when they make bad loans or buy bad assets. It's as simple as that. From the perspective of the banking system, the whole system is sound as long as all banks make sound credit risk assessments. If the system as a whole makes a lot of un-creditworthy loans, then the inevitable result is a contractionary monetary base as loans are written off, and money is destroyed via the bank multiplier effect. This is one key reason why governments are loathe to let large banks fail, because a rapidly shrinking money supply would be disastrous for the economy as a whole. I believe this is why the Federal Reserve has maintained a loose monetary policy throughout the credit crisis. Some commentators contend that this stokes the fires of inflation and I have to agree. But I don't see any other choice.

Commercial banks also have to manage the risk of using short term funds (deposits, debt) to fund long term loans. This is a problem that all banks face, and a good bank should be able to manage this risk to an acceptable level. If we look at it from the perspective of the banking system then this risk becomes a non-issue, as long as bank depository institutions continue to be the only institutions allowed to take deposits and make loans. At the system level, all deposits (short and long term) have to remain within the system, and will continue to fund the issuance of loans (short and long term) which are also completely held within the banking system.

Why banks are good investments
The banking system as a whole channels all the money supply in the economy, so the profits from the banking system will generally grow in line with the growth of the money supply. And since the money supply tends to grow in line with economic growth, the profits from the banking system are a core-inflation protected stream of earnings that grow at the pace of economic growth. In a broad based economy with sound fundamentals, buying a share of the banking system is an excellent way to preserve your wealth. The best lowest risk banks, assuming that not all banks are run identically, would be excellent investments.

Risks and Attracting Customers
Unfortunately, it is difficult to figure out whether a bank is managing its risks well. It is very easy for a bank to make loans to un-creditworthy customers, and it is very difficult for someone reading a bank's financials to know when this has happened. An un-creditworthy customer may be able to pay his/her installments for a few years before finally defaulting on the loan. It's not something you can see coming just by looking at the financials. Assessing a bank's credit risk profile is an art. Among other things, we need to look at the bank's business model, operating culture, and compensation incentives. The price of credit is also an integral part of assessing a bank's credit risk profile. A bank can be financially sound if it makes loans to less creditworthy customers, as long as it charges a higher interest rate for each loan. Netted over a large base of customers, the higher interest rates can make up for the higher number of loan defaults. But it is generally difficult to know whether a bank has adequately priced for the risks that it is undertaking, because loan default typically only show up after a loan has aged for a while. Because of this, it is also easy for a bank to underprice its loans to gain market share, without showing signs of distress in the initial few quarters.

Good banks also need to be able to attract customers. But banking is the business of supplying money, which is the ultimate commodity product. A dollar bill from one bank is as good as a dollar bill from another bank. This doesn't mean that banks can't differentiate themselves using clever retailing, marketing, better service and so on. But it does suggest that, as with all commodity businesses, customers will be willing to switch to a competitor if the competitor's price is low enough. Because banks (1) are such highly leveraged businesses, and (2) it is easy for competitors to underprice their product, a bank can easily become susceptible to a loss if irrationally aggressive competitors attract their customers away with unrealistically low prices. The corollary of this is that a sound bank is one that has customers who don't see it as a commodity provider. Identifying a sound bank means knowing which banks have such customers.

Investing in Banks
Investing in individual banks is not for the uninformed. A bank's high level of leverage means that small errors of judgment by the bank can send the bank into a downward spiral. Flighty customers, underpriced risks, bad credit risk management can precipitate a deadly run on the bank.

The premise that regulator will not let a bank fail, and hence a bank is a failsafe investment, is a false one. I think it is true that bank regulators are loathe to let the bigger banks fail, but this only means that they will protect the assets and liabilities of the bank. They will have to let the shareholders be wiped out, in order to prevent moral hazard from creeping in. The experience of failed banks like Northern Rock and Continental Illinois support this observation.

I believe sound banks are an excellent investment, and the recent downturn in the stock market presents a good opportunity to buy into good banks at a good price. The trick is to pick out the good banks from the bad, before the market cottons on.