Understanding and investing in banks

“First, let’s analyze why the financial crisis occurred. If I could sum up the catastrophe in one word, it would be ‘leverage.’ “

Steve Eisman (reimagined as Mark Baum in The Big Short)

Over the last few weeks we’ve looked at a collection of metrics designed to identify above average companies. These were:

  • Growth Rate: The per share growth rate of revenues, capital employed and dividends over the last ten years
  • Growth Quality: The consistency of per share revenue, earnings and dividend increases, as well as the sustainability of capital employed growth, all measured over the last ten years
  • Net Profitability: The average net return on lease-adjusted capital employed over the last ten years
  • Debt Ratio: Total borrowings and lease liabilities compared to ten-year average earnings

These metrics work for the majority of companies, but for a variety of reasons they don’t work for banks. Since banks only make up a very small part of the UK stock market, one entirely reasonable response would be to simply exclude them from your investment universe.

However, I have nothing against banks in principle, so I would like to be able to analyse them and invest in them if the combination of quality and value are attractive.

So this week I want to focus on a couple of points. First, what makes banks different to other businesses, and second, what bank-specific metrics do we need to analyse them?

Table of Contents

What makes banks different to other businesses?

At the risk of stating the obvious, banks are lenders. They lend money to people and businesses in the same way that landlords lend (lease) property to retailers and equipment hire firms lend equipment to builders.

In each case, the customer:

  • gets access to an asset (such as money, a shop or a digger),
  • pays a fee (interest, rent or a hire fee) and
  • returns the asset to the lender at the end of an agreed term.

So far banks seem to be the same as any other lender, but there is a difference. The difference is that money, unlike property or construction equipment, is a pure commodity. In other words, £100,000 borrowed from one bank is identical to the same amount borrowed from another bank.

While there may be minor differences between one bank and another, in most cases banks are very undifferentiated and add very little value beyond the simple act of lending money. This is a problem because without differentiation it’s incredibly hard to earn sufficiently attractive returns.

One way to boost returns is to take on debt, otherwise known as leverage. If a bank can borrow very large amounts of money at very low interest rates and lend it out at higher interest rates, then it may be able to generate attractive returns, despite the commodity-like nature of its business.

The main way that banks borrow large sums of money very cheaply is to offer deposit accounts such as current and short-term savings accounts.

These cost very little (current account interest rates are notoriously low) and since customers rarely switch banks, the funds typically stay with the bank for many years. These deposits can then be used to fund all manner of long and short-term loans.

So the first thing that’s different about banks is that they almost always have huge amounts of interest-bearing debt in the form of customer deposits. If we count customer deposits as borrowings from the banks point of view then the Debt Ratio will almost always be stratospherically high. In other words, the Debt Ratio in its standard form just doesn’t work for banks.

However, balance sheet strength is still important, so we’ll need to use a different measure of leverage.

The second thing that’s different about banks is their incredibly weak returns on capital. Capital employed is equity, debt and leased capital, but if we count the very large amounts of customer deposits as debt capital then return on capital for banks would always be unacceptably low. As a simplistic example, a bank charging 6% on loans where the source of funds (i.e. customer deposits) costs 2% would earn a return of 4% on those deposit. Since customer deposits make up the bulk of a banks capital employed, the return on capital employed figure would also be close to 4%, and 4% is a terrible return on capital employed.

This means we’ll need to update the Profitability metric as well.

Another difference is that bank’s don’t have revenues as the top line of their income statement. In most cases they’ll have interest income instead.

Since revenue is used in the Growth Rate and Growth Quality metrics, these will need to be updated as well.

In summary then, we’ll need bank-specific versions of the Debt Ratio, Profitability, Growth Rate and Growth Quality metrics. Of these, the first one I look at when analysing a company is Growth Rate, so let’s start there.

Updating Growth Rate for banks

The first problem with Growth Rate is that it uses revenue per share and banks don’t report revenue, so clearly something has to replace revenues. But what?

An alternative to revenues for banks

The Growth Rate metric includes revenue because it’s the total amount of money coming into a business from its customers. This is important because it’s the original source of cash from which all future earnings and dividends flow. If revenues per share aren’t growing then any earnings and dividend increases will not be sustainable in the long run.

For banks, the top line of the income statement is usually interest income, which is the total amount of interest earned from the bank’s loans.

However, interest income is affected by central bank (e.g. Bank of England) interest rates, so a bank can see its interest income increase simply because central bank interest rates have increased, rather than because the bank is making more loans. To get around this, bank analysts will typically look at net interest income, which is the difference between the interest income on loans and the interest expense on deposits and other borrowings.

Since interest income and interest expense are both affected by interest rates in a similar way, net interest should be less affected by inflation or central bank policy.

Although net interest income is a reasonable alternative to revenue for banks, I think a more fundamental measure of future cash income from customers is the total amount of loans outstanding.

Growing income by lending more money to more people is the most basic and sustainable form of growth for banks, so for me, total loans outstanding is a better replacement for revenues as it’s the original source from which future earnings and dividends will flow.

Total loans outstanding is recorded on the balance sheet as an asset (under various names), and it’s usually the largest asset on the balance sheet. Given that the rest of a bank’s assets exist to support its lending business, I think a reasonable simplification is to measure the growth of a bank’s total assets rather than trying to specifically pick out the loan assets.

That gives us our first bank-specific change:

Bank-specific change

In the Growth Rate metric, use total assets per share instead of revenue per share.

The second component of Growth Rate is capital employed growth. I’ve already said that capital employed for banks can be problematic if we count customer deposits as debt capital, so let’s take a look at that now.

An alternative to total borrowings for banks

Usually I calculate capital as equity (net assets) plus debt (total borrowings) plus leased capital (operating lease liabilities). This doesn’t work for banks because they have to borrow vast amounts of money, much of it in the form of customer deposits, which are then lent out to customers.

To get around this, we need to differentiate between borrowing which is used to fund lending and borrowing for other purposes. Bank borrowings are primarily used:

  • As a source of funds for lending (to be lent out to customers)
  • For capital investments (for capital expenses such as the purchase of property, IT equipment or other long-term business assets)
  • As a capital buffer (to protect depositors when a large number of loans are defaulted on)

Starting with funding for lending, I’m going to ignore these because unlike normal debts, these are not optional. Banks simply must borrow vast sums in order to lend.

I’m also going to ignore, at least most of the time, borrowings which are used to fund capital expenses such as property or equipment. Technically speaking, I shouldn’t ignore these as they’re no different from borrowings in any other business. However, I do ignore them most of the time and here’s why:

“Operational” borrowings for banks are usually quite small. This is because banks aren’t very capital intensive, which means they don’t have lots of expensive long-term capital assets such as factories or machinery to replace or expand.

Normally the size of a company’s operational borrowings doesn’t matter and I’ll make a note of them anyway. However, bank balance sheets can be annoyingly complicated, with many different types of borrowings referred to using a broad array of inconsistent naming conventions. This makes tracking down operational borrowings more difficult, and since they’re almost always small it hardly seems worth the effort.

The only exception is when a bank has made a very large acquisition at some point in the last decade. These are often funded with debt, so if there was a large acquisition then I will check to see if the acquisition involved a significant amount of debt. If it did then I’ll include the outstanding debt in the Debt Ratio calculation.

That leaves us with borrowings which are used as part of the bank’s capital buffer, which you can think of as cash on the balance sheet which is there to protect customer deposits in the event of massive loan defaults.

A simplistic example of bank capital

Imagine a new bank which is launched with £1m of cash, injected into it from shareholders. This is equity capital.

The bank then raises £99m from customer deposits, leaving a total of £100m of cash on the balance sheet.

The bank then lends £95m of that £100m to thousands of individuals, leaving £5m cash on the balance sheet.

Suddenly there is a recession and people lose their jobs and default on their loans. Of the £95m lent out, only £80m is repaid.

The bank now has a £99m liability to its depositors, a £1m liability to its shareholders and only £85m of assets, so it’s £4m short.

Shareholder capital acts as a buffer to protect depositors, so it always absorbs losses first. In this example, shareholder capital is reduced from £1m to zero.

This still leaves the bank £4m short, with a £99m liability to depositors and only £85m of cash in the vault. The bank is now technically insolvent and would need to raise additional emergency capital from somewhere.

So bank capital acts as a buffer to protect depositors. The bank in the example above could have avoided insolvency by having, say, £10m of shareholder capital instead of £1m. That’s sensible, but the problem with shareholder capital is that it’s expensive. Shareholders typically expect a reasonable rate of return on their equity, which usually means 7% per year or more.

If a bank leaves a large chunk of shareholder capital sitting in a vault as cash then it isn’t going to be earnings 7% or more per year. Shareholders might want that money to be invested into more profitable activities or returned to them as dividends so they can reinvest accordingly.

To get around this, banks often borrow money and then leave the cash sitting in a vault (obviously that isn’t what happens in practice, but that’s the basic idea). The whole point of these borrowings is that they act as protection for depositors, so they tend to be very long-term, or even perpetual (i.e. there is no set repayment date). They’re also usually subordinated, which means they’re not secured on the bank’s assets. In practice this allows the bank to use the borrowed funds as a capital buffer, without having to worry about repaying the loan anytime soon or having to fight the lender for control of the bank if things go wrong.

This debt capital is called Tier 2 capital by regulators and its the main form of borrowings I’m interested in, especially in terms of calculating a banks capital employed. It’s also easy to find on the balance sheet by searching for “Tier 2”.

Okay, let’s pause there and look at the changes we’ve made to the Growth Rate metric:

  1. Total assets per share are used instead of revenue per share
  2. Lease-adjusted capital employed per share uses Tier 2 debt capital rather than total borrowings.

Calculating Growth Rate for banks

Now that we have all the pieces, here’s a quick reminder of how to calculate Growth Rate for banks:

Steps to calculate Growth Rate for banks

1) Calculate total assets per share (TAPS) growth:

1.1) Calculate average TAPS for the oldest three years in a ten-year period

1.2) Calculate average TAPS for the latest three years in a ten-year period

1.3) Calculate TAPS growth:

TAPS growth = (new average TAPS / old average TAPS) – 1 × 100%

2) Repeat step 1 for capital employed per share (CEPS), where:

CEPS = shareholder equity PS + Tier 2 debt capital PS + lease liabilities PS

3) Repeat step 1 for dividends per share (DPS)

4) Calculate total growth as the average of TAPS, CEPS and DPS growth:

total growth = (TAPS growth + CEPS growth + DPS growth) / 3

5) Calculate the annual growth required to produce the total growth:

growth rate = ((100% + total growth)^1/ 7) – 100%)

Note: The caret symbol (^) is used to identify exponents, so in the calculation above, “^1/7” should be read as “raised to the power 1/7”. The seven is there because two three-year periods at the start and end of a ten-year period are effectively seven years apart.

We’ll work through an example in a moment, but first we need to make a small update to the Growth Quality metric.

Updating Growth Quality for banks

Growth Quality measures the consistency and sustainability of a company’s growth. The standard Growth Quality score uses revenue, earnings, dividends and capital employed, all on a per share basis.

We’ve already seen that banks don’t report revenue, so we’ll replace revenue with total assets, as we did with Growth Rate. And I’ve already covered the changes to calculation capital employed for banks, so I won’t mention those again.

Steps to calculate Growth Quality for banks

1) Total assets per share: Count how many times it went up over the last ten years

2) Earnings per share: Count how many times it went up over the last ten years

3) Dividends per share: Count how many times it went up over the last ten years

4) Growth sustainability score: Calculate this value as per the description in week 2, using the bank version of capital employed.

5) Total score = sum of 1, 2, 3 and 4 above

6) Growth Quality – total score / 37 * 100% (where 37 is the maximum possible score)

Luckily that’s the only change we need to make to Growth Quality. As always, these calculation are easy to do if you use a spreadsheet.

Let’s move on to the Debt Ratio.

Updating the Debt Ratio for banks

For most companies, the Debt Ratio is the ratio of total debts (borrowings and lease liabilities) to ten-year average earnings. This obviously won’t work for banks, given their enormous but essential borrowings in the form of customer deposits.

We can fix this problem with the same tweak we used to calculate capital employed. In other words, we can narrow our definition of borrowings from total borrowings to Tier 2 debt capital.

This leaves us with the following calculation for the banking Debt Ratio:

Steps for calculating the Debt Ratio for banks

1) Calculate capital debts:

capital debts = lease liabilities + Tier 2 debt capital

2) Calculate ten-year average earnings

3) Calculate the Debt Ratio as the ratio of capital debts to ten-year average earnings:

Debt Ratio = capital debts / ten-year average earnings

That’s the last change required in the core metrics, so let’s have a quick look at the related rules of thumb.

Banking rules of thumb

To keep things simple I use the same rules of thumb for banks as I do for other companies:

Defensive value rules of thumb for banks

Growth Rate: Only invest in a bank if its Growth Rate is above 2%

Growth Quality: Only invest in a bank if its Growth Quality is above 75%

Profitability: Only invest in a bank if its ten-year average return on capital employed is above 10%

Debt Ratio: Only invest in a bank if its debt ratio is below 4.0 (the limit is 4.0 as banking is a cyclical industry)

Additional ratios for banks

So far we’ve looked at some tweaks to my core metrics so that they work for banks. In addition to these tweaks, I use a small number of additional measures just for banks, to help me assess a bank’s robustness and profitability, both of which are important factors given their highly leverage nature.

The first bank-only ratio is designed to find banks with exceptionally large equity capital buffers and therefore (hopefully) exceptionally robust balance sheets.

The Tangible Equity Ratio

As we now know, shareholder equity acts as an important buffer to protect depositors in the event of significant loan defaults.

Here’s another quick example, showing how shareholder equity can successfully protect depositors during an economic downturn:

Like the example bank we looked at earlier, this one also has £99m of customer deposits. Unlike the previous bank, this one has £11m of shareholder equity rather than £1m, leaving it with £110m in the vault.

As before, the bank loans £100m out to small businesses and homebuyers, leaving £10m in its vault as a cash float and capital buffer. Unfortunately there’s a recession and this bank suffers the same default rate as the previous bank, so £5m of its loans go unpaid.

This is not good, but unlike the previous bank, these defaults do not leave the bank insolvent. Instead, £95m of loans are repaid, leaving the bank with £105m in its vault. This is more than enough to cover all £99m of customer deposits, leaving shareholders with a reduced but still positive £6m of equity.

So depositors have been protected at the expense of shareholders, and that’s exactly as it should be.

The important point here is that by having a sufficient buffer of equity capital, a bank should be able to absorb significant loan defaults without having to suspend its dividend or raise additional equity through a rights issue.

The size of a bank’s capital buffer is something regulators keep a close eye on, primarily through the Common Equity Tier 1 Ratio (CET1). This is the ratio between shareholder equity (with a few adjustments) and risk weighted assets.

There are of course regulatory minimums for CET1 which banks have to meet. In my experience though, these regulatory minimums are not nearly high enough, and many banks with “acceptable” CET1 ratios have run into serious problems, largely as a result of their weak balance sheets.

This is why I prefer to use the Tangible Equity Ratio (TER), which is a far less forgiving ratio than CET1.


Tangible assets: Total assets minus intangible assets. For most banks the main tangible assets are loans made to customers.

Intangible assets: These are assets which are not physical, such as acquired goodwill, which is the price paid for an acquired company above its balance sheet net asset value. Intangible assets are hard and sometimes impossible to convert into cash.

Tangible equity: Net tangible assets, i.e. tangible assets minus all liabilities (liabilities are always tangible).

The key difference between CET1 and TER, other than the fact that TER typically works out to be far lower than CET1, is simplicity.

Both CET1 and TER are ratios between equity and assets, but TER just uses tangible equity and assets and ignores the complex adjustments and weightings that CET1 applies.

Also, excluding intangible assets is good because intangible assets like acquired goodwill or intellectual property can be hard or impossible to turn into cash, and cash is what depositors want when they want their money back.

Steps for calculating the tangible equity ratio

1) Calculate tangible assets:

tangible assets = total asset – intangible assets

1) Calculate tangible equity:

tangible equity = tangible assets – total liabilities

3) Calculate the tangible equity ratio:

TER = tangible equity / tangible assets * 100%

A sensible minimum for the tangible equity ratio

If we look back at the financial crisis it’s easy see what was and wasn’t a sensible tangible equity ratio. It’s easy because most UK banks had very significant problems during that crisis, and most of those problems were self inflicted through excessive leverage and excessively thin equity buffers.

For example, in 2008, all large UK banks had tangible equity ratios of less than 4% and in some cases less than 2%. In other words, some UK banks would have become tangibly insolvent if a mere 2% of their loans were defaulted on. That was a recklessly thin margin of safety as the banks and their investors subsequently found out.

Since then, most banks have increased their equity buffers and today many have a tangible equity ratio of 5% or more. That’s obviously better than 2%, but it isn’t good enough for me.

I don’t have to invest in banks, so if I’m going to invest in a company which is highly leveraged by nature, then I only want to invest in those with abnormal levels of prudence and balance sheet strength.

For me that means demanding an average tangible equity ratio which is comfortably above the average of any large UK bank:

Defensive value rule of thumb

Only invest in a bank if its ten-year average tangible equity ratio is above 10%.

In recent years, only small and specialist lenders have been able to exceed that 10% hurdle rate. That’s fine by me, because in my experience niche lenders tend to make better investments than the highly commoditised high street banks.

Close Brothers’ tangible equity ratio

Close Brothers is a merchant bank listed in the FTSE 250. It’s the only bank I’ve owned over the last few years and it has an unusually strong balance sheet. This shows up as a high average tangible equity ratio, which you can see in Table 6.1.

YearTan. EquityTan. AssetsTER

Table 7.1: The tangible equity ratio (TER) for Close Brothers

As the table shows, Close Brothers has consistently had a tangible equity ratio above 10%. That’s a very wide equity buffer indeed, and it gives me some confidence that this bank can protect depositors if loan default rates surge during lean economic times.

This strong equity buffer is in fact a key part of the company’s strategy. Close Brothers nurtures deep relationships with corporate customers who need a bank that can continue to lend even during deep recessions. That is precisely when many of its customers need additional emergency funds, either to replace profits which are temporarily depressed or to invest in expansion while other companies are retreating.

Next week: Insurers

Having covered banks this week, our next step will be to look at insurers, which in many ways are quite similar to banks. We’ll be reusing some of the updated metrics from this week and introducing some insurer-specific measures as well.