Sunday, 16 May 2010
INvestor's Checklist: Banks
- credit,
- liquidity and
- interest rate.
Excellent checklist. This excerpt from Pat Dorsey's The Five Rules for Successful Stock Investing provides a concise, powerful framework for analyzing banks. Let's break it down, discuss its strengths and add necessary context.
Summary & Core Thesis
Dorsey argues that bank investing is fundamentally about analyzing risk management. A good bank isn't just about profit growth; it's a conservatively-run institution that expertly navigates credit, liquidity, and interest rate risk to generate steady returns across economic cycles. The checklist emphasizes quality (conservatism, competitive advantages), financial discipline (asset-liability matching), and valuation (price-to-book).
Analysis & Discussion of Key Points
1. The Three-Risk Model (Credit, Liquidity, Interest Rate):
This is the foundational insight. Everything flows from here.
Credit Risk: The risk loans won't be repaid. This is where most bank failures begin (e.g., the 2008 crisis, regional bank crises driven by bad CRE loans). Dorsey's emphasis on conservative provisioning is key—it shows a bank is realistic, not optimistic, about its loan book.
Liquidity Risk: The risk a bank can't meet short-term obligations. This is what causes runs (e.g., Silicon Valley Bank, 2023). A bank can be solvent (assets > liabilities) but fail if it can't access cash.
Interest Rate Risk: The risk that changing rates will hurt profitability. If a bank funds long-term, fixed-rate loans with short-term deposits, rising rates crush its net interest margin (NIM). Point #4 on duration matching is the direct prescription for this risk.
2. The Emphasis on Conservatism:
This is the most crucial takeaway for an investor. In a leveraged, risk-taking business, survivors are conservative. A "large equity base" (high capital ratios) is a buffer against losses. Conservative provisioning builds reserves in good times for the bad times. This discipline often means slightly lower returns in booms, but ensures survival and market share gain in busts.
3. Competitive Advantages (The "Moat"):
Dorsey's list is spot-on and explains why good banks are phenomenal businesses:
Cheap Funding: The ability to take insured deposits is a huge, government-backed advantage.
Economies of Scale & Network: A branch network is expensive to build and creates a local oligopoly.
High Switching Costs: Changing your business checking, payroll, and credit lines is a massive headache.
Capital Intensity & Limited Exit Barriers: It's hard to start a bank, but easy to sell a loan book or the whole bank. This reduces "do-or-die" competition.
4. Financial Metrics (ROE, ROA, Price-to-Book):
ROE & ROA: For banks, these must be evaluated together. A very high ROE driven by extreme leverage (low equity base) is dangerous. A solid ROA (e.g., consistently >1%) indicates true operational efficiency.
Price-to-Book (P/B): The go-to metric because bank assets and liabilities are mostly marked-to-market or held at values close to book. However, P/B must be used in context. A bank trading at a low P/B might be cheap, or it might be a value trap with a hidden, deteriorating loan book. A high-quality bank with a high ROE and low risk often deserves a higher P/B multiple.
Critique & Modern Context
While timeless, the checklist needs some updating for the post-2008/GFC and post-2023 (SVB) world:
Regulatory Environment is Crucial: Dorsey's era was pre-Dodd-Frank. Today, an investor must understand a bank's regulatory status (e.g., GSIB, CCAR stress testing for large banks). Capital requirements (CET1 ratio) are now a non-negotiable metric.
Liquidity is Even More Prominent: The SVB collapse put a laser focus on liquidity coverage ratios (LCR) and the dangers of holding long-dated securities (HTM vs. AFS portfolios) in a rising rate environment. Duration matching (#4) is now a survival issue.
Fee Income & Diversification: The checklist implicitly focuses on traditional lending. Today, the mix of revenue matters. Reliance on volatile investment banking or trading fees adds another layer of risk. Stable, "sticky" fee income (e.g., wealth management, custody) is highly valuable.
Technology as Moat & Threat: An "established distribution network" (branches) can now be a liability if it's not paired with robust digital banking. Fintechs are eroding certain profitable niches (payments, lending). Tech spend is now a key competitive factor.
Updated Investor Checklist (Synthesizing Dorsey & Modern Insights)
Risk Management Culture First: Look for conservative underwriting, prudent provisioning (allowance for loan losses relative to NPAs), and a management team that discusses risk with clarity and fear.
Strong, Clean Capital & Liquidity: Analyze CET1 Ratio (well above requirements) and Liquidity Coverage Ratio. Scrutinize the securities portfolio—is it dangerously mismatched with deposits?
Steady, Diversified Earnings: Seek consistent growth in Pre-Provision Net Revenue (PPNR)—profit before loan losses. This shows core strength. A healthy mix of net interest income and stable fee income is ideal.
Proven Through the Cycle: Examine performance during the last recession (2008-09) and the 2020/2023 volatility. Did the bank remain profitable? Did its capital base hold up?
Valuation in Context: Use P/B relative to ROE and risk profile. Compare a bank's P/B to its own historical average and to peers with similar ROE and asset quality. A high-quality bank at a moderate P/B is better than a risky bank at a low P/B.
Final Comment
Pat Dorsey's checklist remains one of the best starting points for understanding bank investing. Its core principles—conservatism, risk management, and valuing a bank as a steward of risk rather than a pure growth engine—are timeless. The modern investor's task is to apply these principles using the enhanced regulatory and analytical tools developed since the book's publication, with a heightened focus on liquidity and the technological landscape. By doing so, they can identify those rare institutions that are not just banks, but durable, high-quality compounders.
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