The following article should not be taken as investment advice and is for information purposes only

For most people who invest in stocks, whether through building a blue chip portfolio themselves or through mutual funds/ETFs, they are usually invested in bank stocks. The big banks are an important part of every economy and there are obvious consequences when they fail (as evidenced by the financial crisis).

Otherwise, financials are generally a large part of the total market float in every country and the biggest banks are generally associated with being stable companies that pay a growing dividend.

However, the bank universe is not limited to major names such as Citi, JP Morgan Chase, Bank of America and Wells Fargo (or Barclays and HSBC, or any major banking group in any country). There are plenty of opportunities to invest in a fragmented industry that grows as the economy grows and as consumers need credit.

A bank primer exists for people looking to learn more about how banks make money as well as for aspiring financial institutions group investment bankers. This post goes more in-depth on what matters when looking at a bank as an investment.

Factors that Influence Bank Stocks

Higher Interest Rates and the Product Mix

In most cases, bank stocks will appreciate when interest rates are expected to rise. This is for various reasons:

1. Rising interest rates means a strong economy (central bank raises rates to make sure inflation is not excessive) which generally means loan growth/credit growth – the volume of what the bank is selling is rising
2. Banks make money from lending by lending out at a higher interest rate than what they pay depositors (or however else they raise their funds) – higher interest rates mean that they will charge higher interest rates while their cost of funds stays low (for instance, the interest rate given to someone with a chequings account is zero or very low)
3. Banks will invest a certain amount of assets in fixed income instruments (they cannot invest in equity – as alluded to above, banks are an important part of a stable country and deposits are not allowed to be invested into risky assets) – as interest rates rise, the coupon they lock in from holding bonds and other fixed income securities to maturity rises

So for investors looking at bank stocks, they should have a view on:

• The Fed Funds Rate (or any relevant central bank rate)
• 1M LIBOR (or any relevant bank-to-bank rate)
• 3M LIBOR
• 5Y Treasury

LIBOR is a floating rate and means higher lending revenues. The treasury is a relevant risk free rate benchmark for fixed income securities and a rising 5Y means that investment income will rise.

Growing Banking Product Suite

Interest rates rising are a good thing for the bank’s existing business, but a thriving bank should experience growth across all of its revenue platforms.

Loan growth is possibly the most important. The more a bank lends, the more profit it makes. A growing loan book with stable and healthy net interest margin (the rate the bank lends at less the rate the bank funds at) is good. Of course, banking is very much a risk business and banks need to ensure that they are fairly compensated for the risk that they are taking. As such, a bank that lends blindly will eventually pay when debtors cannot service interest or principal and loan losses rise.

Deposit growth is also extremely important. Soliciting new depositors means a cheaper cost of funds for the bank’s treasury. Banks do not lend out all of their deposits (the loan to deposit ratio is a key financial metric), so by growing their deposit base it gives them the liberty to lend more money.

Non-Interest Income and Non-Interest Expenses

Fee income is secondary, but is a sticky source of bank revenue. Most retail consumers complain about fees, but retail consumers are generally sticky as the cost of switching banks is high and is a particularly onerous process. However, egregious fees plus lacklustre customer service may result in higher customer churn. The more concentrated the bank market, the harder it is to get away with rising fees and bad customer service.

Believe it or not, the biggest beneficiaries and possibly why there is so much resistance to adopting a cashless model such as in China (where mobile payment technology has leapfrogged the US and Europe by bypassing credit cards altogether) of credit cards are the banks. Although Visa and Mastercard dominate the payment universe, the banks always negotiate a major part of credit card revenues (obvious read through is that the bigger the bank the more leverage they have in terms of capturing more of the fees). Visa and Mastercard actually make a lot more money on the back end through processing and payment platforms.

High credit card spend means juicy profits, especially in the US where credit cards are also seen as an expensive but not uncommon line of credit that is drawn (at 11% interest). Banks will accordingly offer incentives to have credit card balances moved over to them or perks such as points and rewards to get consumers using their credit cards.

The Efficiency Ratio for Bank Stocks

Efficiency Ratio = Expenses/Revenue

The efficiency ratio is what % of revenues expenses comprise of. This is quoted in every bank stock earnings call and CEOs always make it a point to be improving the efficiency ratio.

However, the efficiency ratio is not particularly efficient in comparing one bank to another because of the differences in product mix. For example, a bank that has a lot of insured mortgages may be “less efficient”, but in reality have a much more stable business than one that is in higher risk loans.

Instead, the efficiency ratio should be looked at versus the bank at a prior time period. The ratio is a good way to see how the bank has improved.

Every bank executive will say that you can improve the efficiency ratio by cutting costs… or by raising revenue, and they almost always choose to go for the latter. Revenues rising faster than expenses allows a bank to grow into a lower efficiency ratio, but accelerated growth has to be scrutinized to see if the bank is taking on the appropriate risks and the growth comes from a competitive advantage such as excelling in a niche.

However, the bank’s management team cannot always look at cutting costs and staying lean – banking is a business that requires constant innovation. Banks that do not invest in technology or high performing staff will see their efficiency ratio fall later as revenue sags or operations fall behind.