Private banking institutions are one of the most important institutions in society. The banking system is responsible for acting as the key intermediary between credit-worthy borrowers and savers, efficiently allocating capital towards productive uses. In addition, banks are essential in maintaining financial stability and facilitating the transmission of monetary policy. Given their role in the economy, I find that banks are mostly overlooked–after all, credit is a commoditized good with little competitive moats existing. This quick write-up looks to address how I think an equity investor should evaluate banks at a high level.

Business Model

The business model of a bank is relatively simple to understand. Banks take in customer deposits (liabilities on their balance sheet) and loan (assets for the bank) those funds out — charging an interest rate to act as compensation for the risk of default. To entice customers to deposit at a bank, they also pay interest on customer deposits. The difference between the interest paid on customer deposits and loans is known as the net interest margin (NIM). The NIM is arguably the most important metric in personal and commercial (P&C) banking. Though, banks don’t always have to loan out their deposits. Instead, they could invest those funds into–typically fixed rate–marketable securities (i.e., mortgage backed securities, corporate bonds, treasuries). To help soften the potential impacts of a defaults on loaned funds a bank investor would want equity capital to be built up in anticipated for unexpected (above provisioned) credit losses.

Banks of course have other divisions beyond retail banking that make them money. The most important to consider are a bank’s business in wealth management, capital markets, and asset management. Realistically, only of these strikes me as having the potential to be an above average business – wealth management. First, the capital markets business has its pros and cons. On the pros, the business can be strategic to corporate relationships and during economic expansions can be a source of revenue growth. On the flip side, the capital markets business has the negatives of cyclicality, high regulatory burden, and can have higher compensation costs (excluding the cost of employee turnover). The asset management business has the same issues though it is a bit more defensible in that it generates recurring management fees, however, fierce competition leads to fee compression. This leaves us with the wealth management business which tends to be stickier and creates opportunities for cross-selling (e.g., estate/tax planning). The recurring nature of the wealth business increases its attractiveness which is only further supported by demographic tailwinds that will keep the business growing through cycles.

Value Creation & Banking Analysis

Using a DuPont model to breakdown ROE, we know it is the product of return on assets (ROA = Net Income Assets) and asset leverage (assets/equity). Asset leverage is an inherent feature of the business model and cannot really be messed with–juiced up–because of regulation and the unease depositors would have if credit risk in loan book is underwritten solely with their deposits.

First, looking at ROA we consider that it is derived by net income divided by assets (primarily loans). The key drivers of net income for a bank then is the bank’s NIM and their fee yield. The fee yield refers to income earned from non-interest sources (e.g., wealth management fees, M&A fees, etc…). With respect to expenses, the most prominent are vanilla operating expenses and credit costs. As the asset leverage is hard to grow, for a bank to have a moat it must be better than competitors along one of the four elements (NIM+Fee Yield-OPEX-Credit costs) determining net income. You would imagine that all businesses have minimized their operating expenses so only three of the elements can really be differentiated.

Here’s how each of the three elements can achieve differentiation. A bank with a strong franchise may have stickier deposits that require lower interest payments–as they are only trusted intermediary–reducing the cost of funds and growing the NIM. They could also have a highly sought after wealth management or capital market franchise that juices up their fee yield. Finally, they could possess a clairvoyant ability to see which borrowers are actually likely to default, enabling them to minimize their credit losses (this is where most fintech institutions claim they can leverage technology to get an advantage). It is quite difficult to get some of these advantages to oneself but there are cases where a bank is able to defend a moat.

Ultimately, banks are in the business of allocating credit to customers and that credit is a commodity. The consumer doesn’t care where it comes (TD, Scotia, etc…) as long as its cost is cheap and the friction in transaction minimal. For this reason, banks in my opinion are inherently poor businesses. The business models necessitate leverage–in the form of customer deposits–to sell commodity products, I couldn’t think of anything worse. Yet, there are examples of banks that have delivered impressive long-term results (e.g., Handelsbanken in Sweden, DBS in Singapore, and a few North American names as well).

Choosing Between Banks

I’ve discussed what matters in banking and shareholder returns, next is to examine the differences in banks and which you’d rather own. The first dimension to analyze should be deposits. There are two important differentiators when considering deposits: their stickiness and their cost. An investor would like to see a bank’s deposits be low interest bearing–zero being the best–and sticky. Simply, you wouldn’t want the largest liability you possess to have a high cost associated with it and you certainly wouldn’t want deposits to disappear (your short term liabilities being called early) in a whim. Were this to happen then you would be forced into selling your assets to allow for customer withdrawals. That could become a problem if the asset side doesn’t reflect risks taken on the liabilities of that bank.

Next, you’d want to consider the quality of the bank’s assets (primarily, its loan book and investment securities). As an equity investor you’d hope the loans are (1) to a diverse group of creditworthy borrowers (2) the borrowers are charged an interest rate that covers the risk of default, (3) and the composition of the loan portfolio is reflective of the nature of deposits (do the liabilities & assets match, aka. asset-liability matching).

A Case Study: Silicon Valley Bank (How Not to Asset-Liability Match)

The 2023 Silicon Valley Bank (SVB) fiasco provides an interesting case study of when liabilities and assets don’t match. SVB”s depositors were mainly emerging technology companies who had been flush in part due to a boom in venture capital. Seeing an increase in deposits, SVB parked their cash in long-term government debt and mortgage backed securities. SVB opted for longer term assets to park cash because the yield they would receive in shorter term options wasn’t satisfactory as they approached zero. SVB’s management were in my opinion, reaching for yield. When the Fed in 2022-23 aggressively raised rates to temper runaway inflation, the value of these assets dropped markedly. SVB’s failure to envision a world where short-term rates weren’t at zero would cost it dearly. When deposits started to leave the bank (a negative of having a concentrated deposit base), the bank was forced to sell their long-term assets (which had lost value) and faced a liquidity crunch. SVB’s liquidity crunch resulted in a classic bank run that left the bank with nowhere left to go. The root cause of SVB’s collapse was their exposure to interest rate risk (due to long-term duration on investment securities), poor asset-liability matching, and flighty depositor base. Great banks do not have these characteristics and are thus less likely to meet complete loss in the same fashion as SVB did.

**As an aside, the accounting treatment of HTM (held-to-maturity securities differs to available for sale [AFS] securities which are marked to market, so one easily notices changes in values.

The banking business is competitive, regulatory complex (I didn’t even go over some of the metrics of importance like CET ratios and RWA), and inherently levered. I would never call it a good industry for shareholder returns, however, I believe it is important to understand it as opportunities can arise regardless. When dislocations happen, whether due to credit fears, regulatory overhang, or misunderstood balance sheets, banks can trade at deep discounts to intrinsic value and present compelling setups for the patient investor.