Investing in Bank Stocks

With the current newspaper reports about financial credit and problems with mortgage lenders, the importance of knowledge when investing in bank stocks is even more relevant. Lack of such knowledge can lead to substantial losses, as any investor in the UK bank Northern Rock will tell you. This bank’s problems wiped out 90% of its share value in the three months to September 2007, most of that occurring within the latter three weeks.

Essentially banks are in business to make money the same as any other commercial organisation. The only differences being that the product they buy and sell is money and the majority of their income is generated from interest movements. The margin between the interests they pay to depositors and charge to borrowers is their net income, more commonly known as net interest. However, this situation is not quite as clearly defined as it use to be. Now, most of the major banks, which include organisations like Citicorp, Wells Fargo, U.S. Bancorp and Keycorp amongst many others, have increased their range of income generating activities into other industry sectors such as insurance.

Whilst, like any other investment decisions, you are looking for a business that can deliver continued growth in value together with a reasonable dividend yield, there are several other key metrics you should look at when considering adding a bank to your portfolio.

The first of these relates to the growth pattern of a bank’s deposit and loan figures. If the level of deposits held show signs of slowing down this means that the bank may have to secure funds from elsewhere to maintain its lending program. These funds are likely to be more expensive, thus leading to a narrowing of the net income achieved. A similar effect will be seen if the rate of loan advances slows. In this case the bank will be generating less income, which will again affect their profitability.

Secondly, one should review the asset quality and loss provisions. The assets in this case will include the balance of loan capital repayment and the stronger this is the better the bank’s ability to return a good future performance. This strength can be measured by looking at the loss provision made. The loss provision is the amount the bank has set aside to cover any problems likely to attach to recovery of loans, such as defaults and failures of the borrower. The higher this position is the less stable the quality of the bank’s assets is likely to be.

However, the size of the loss provisions when measured as a percentage of the loans asset also needs to be considered. The Federal bank has in the past expressed concern that some of the banks have not allowed a sufficient level of provision. This can create future problems for a bank. For example, if the loss provision has been set at 1.5% of the loan portfolio, but in reality it turns out to be 3%, the deficit between the two will have serious consequences for the bank’s profitability and stability. Therefore you need to check that a particular bank’s provision in this respect is in line with other market players.

The third stage is to look at liquidity. This will tell you how capable the bank is of being able to effectively react to market opportunity. In this respect the greater the level of cash and securities held by the bank, particular when compared with the loan capital outstanding, the more flexible that bank will be and therefore able to take advantage of change and opportunity faster than others.

Although the above are amongst the most important, there are a number of other metrics that should be considered. For instance, external factors such as the decisions of the Federal Bank and the strength of the housing market will impact upon the banking sector performance generally. Individually, decisions taken by management will also have an effect and, to assess this, you need to be viewing the likely effects of any comments made by management in respect of their bank’s business direction and strategy.

Finally, when comparing banks, you need to ensure that you use like-for-like models. Some banks have more non-interest income than others, which can make comparison less accurate if you use the wrong comparatives.

Before investing in bank stocks you need to analyse the past performance, compare with similar organisations and make sure the prevailing metrics and external factors are favourable and likely to remains so for the period of your intended investment.