Strategies for Banks to Make a Profit in a Low Interest Rate Economy

By Steve Lander

Low interest rates don't have to eliminate a bank's profitability. 

A low interest rate economy can be challenging for the banking sector. After all, if banks earn profit by lending out money and they can't charge as much for the money they lend, it's harder to maintain the same level of profitability. However, low interest rate markets still offer opportunities for banks to do extremely well. These strategies are as open to small community and business banks as they are to the largest institutions. 

Fee Revenue 

Instead of earning money by borrowing and lending money, banks can turn to fees to boost profits. For example, banks can charge overdraft fees when customers try to draw money that they don't have from their accounts. One $35 overdraft fee per year generates as much revenue as lending out $1000 at 3.5 percent for the year. Banks can also charge ATM usage fees, account maintenance fees, statement copy fees and just about anything else they can imagine. 

Origination and Turnover 

Another option for banks is to continually recycle their money, such as in the mortgage market. Instead of making a traditional 30-year mortgage loan and tying up their income for a long period of time, banks can make and sell loans. When the bank makes the loan, it ties up a portion of its capital in the loan at a low interest rate. However, the bank can turn around and sell that loan to an investor and, hopefully, realize a profit on the sale. The bank then has the money back to lend again so that it can continue flipping the funds. 

Changing the Spread 

When the rate that a bank can charge plunges, it creates an opportunity for them to increase their profit by charging a little bit more relative to the market. For example, if mortgage rates should go from 8 percent to 4 percent, it's unlikely that a customer would complain or even notice if the bank dropped its rate to 4.25 percent instead. After all, the customer is still saving a great deal of money relative to previous rates. Doing this helps to cushion the blow of low rates and protect or even increase bank profits. 

Rates Don't Matter 

A low interest rate market cuts both ways. While banks can't charge as much for loans, they also don't have to pay as much to attract deposits. Historical data from the Federal Reserve comparing the prime rate to the rate on a three-month certificate of deposit shows that they trade in a relatively tight band. Between 1995 and 2012, the average difference between the two rates was 275 basis points, and the spread varied between 212 and 320 basis points. When you take out the highest and lowest spread years, the range narrows to 267 to 297 basis points -- which is just over a 10 percent difference during 16 years of the 18 year period. For comparison, during that same period, the prime rate fluctuated from 3.25 to 9.25 percent and CD rates fluctuated from 0.28 to 6.46 percent. In other words, while rates change, the bank's profit, which comes from the difference between the deposit and loan rates, remains roughly similar.

https://smallbusiness.chron.com/strategies-banks-make-profit-low-interest-rate-economy-68922.html

Valuing Banks

There are four complications in the valuation of banks:

1. the latitude managers have with respect to accounting decisions,
2. lack of transparency,
3. the level of leverage, and 
4. the fact that banks are multibusiness companies.

Those businesses include

1. borrowing and lending,
2. underwriting and placement of securities,
3. payment services, 
4. asset management, 
5. proprietary trading, and 
6. brokerage.

DCF on operations approach is not appropriate

In valuing a bank, a discounted cash flow (DCF) on operations approach is not appropriate because interest rates revenue, and costs, are part of operating income.



Equity DCF method is more appropriate

The equity DCF method is more appropriate, and the analyst should triangulate the results with a multiples-based valuation.

The equity approach uses a modified version of the value driver formula in which

• return on equity (ROE) and return on new equity (RONE) replace ROIC and RONIC, and 
• net income replaces NOPLAT:

Current Value at time t = Net Income at time t+1  *  [1 - (g/RONE)] / ke - g

ke = cost of equity


Problems and complications in bank valuations

Problems associated with applying the equity DCF valuation method include

• determining the source of value, 
• the effect of leverage, and 
• the cost of holding equity capital.

Economic spread analysis can help determine the sources of value creation.

Other complications in bank valuations are

• monitoring the yield curve and forward rates, 
• estimating loan loss provisions, 
• approximating the bank's equity risk capital needs, and 
• constructing separate statements for each of the bank's activities.

Asset-Based Valuation

Asset-Based Valuation uses market values of a company's assets and liabilities to determine the value of the company as a whole.

Asset based valuation works well for:

• Companies that do not have a significant number of intangible or "off-the-book" assets, and have a higher proportion of current assets and liabilities.
• Private companies, especially if applied together with multiplier models.
• Financial companies, natural resource companies and companies that are been liquidated.

Asset-based valuation may not be appropriate when:

• Market values of assets and liabilities cannot be easily determined.
• The company has a significant amount of intangible assets.
• Asset values are difficult to determine (e.g., in periods of very high inflation).
• Market values of assets and liabilities significantly differ from their carrying values.

Value Investing Opportunities in the Banking Sector

Opportunities available for value investors in the banking sector. 

In the mid-1980s to early 1990s, many banks were selling for less than book value. 

During the recession of the early 90s, many banks had to be bailed out by the government due to some of the high-risk loans they had offered and due to the general downturn in the US real-estate market...remind you of today?

Apart from the top 10 to 20 largest banks, Wall Street analysts did not follow thrifts.

As a result, small and mid-sized shops were trading at inefficient prices, allowing value investors to purchase some companies at a large discount.



Some elements of valuing banks. 

Many banks are "un-analysable", for example if they deal in junk-bonds or complex mortgage securities or other exotic lending instruments.

Conservatism is of the utmost importance when valuing companies in this industry, due to the fact that they are highly leveraged and thus already contain a certain amount of risk.

Book value is a good start for valuing a bank, but is usually a conservative estimate of what it is worth.

• Book value should be adjusted upward for understated assets such as appreciated investment securities, below-market leases, real estate carried below cost and a stable customer/deposit base. 
• Investors must also be on the lookout for items that should be used to adjust book value downward, such as intangible assets, bad loans and poor investments that are carried at cost.

There are no sure things in this banking industry. 

These factors play large roles in determining whether an investment will have a good outcome:

• asset quality, 
• management discretion, and 
• interest rate volatility 

All investors can do is pick low-risk individual banks with the best prices to their fundamentals and hope for the best.

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

A Guided Tour of the Market 4

Banks

[...] the heart and soul of banking is centered on one thing: risk management. Banks accept three types of risk: (1) credit, (2) liquidity, and (3) interest rate, and they get paid to take on this risk.

One of the biggest challenges to investing in banks is spotting credit quality problems before they blow up in investors' faces. To help avoid getting stuck with a bank that blows up, investors should pay close attention to charge-off rates and delinquency rates, which are seen as an indicator of future charge-offs.

Beware of super-fast growth. It's an axiom in the financial services industry that fast growth can lead to big troubles. Fast growth is not always bad – many of the best players have above-average growth rates – but any financial services company that's growing significantly faster than competitors should be eyed with skepticism.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

It is easier to make money in some industries than in others.

It is easier to make money in some industries than in others.

Some industries lend themselves to the creation of economic moats more so than others.

These are the industries where you will want ot spend most of your time.

The economics of some industries are superior to others.

You should spend more time learning about attractive industries than unattractive ones.

Every industry has its own unique dynamics and set of jargon.

Some industries (such as financial services ) even have financial statements that look very different from others.

Wade through the different economics of each industry and understand how companies in each industry can create economic moats - which strategies work and how you can identify companies pursuing those strategies.

Here are some areas of the market that are definitely worth more of your time exploring.

• Banks and Financial Services
• Business Services
• Health Care
• Media

These are not the four areas of the market with worthwhile investments.

They are highlighted because they contain so many wide-moat companies.

There are great firms in even the least likely areas of the stock market.

The goal is to help answer a few essential questions:

• How do companies in this industry make money?
• How can they create economic moats:
• What quirks does this industry have that an investor should know about?
• How can you separate successful from unsuccessful firms in each industry?
• What pitfalls should you watch out for?

Over the long haul, a big part of successful investing is building a mental database of companies and industries on which you can draw as the need arises.

That will make you a better investor.

8 Buffett Secrets for Investing in Banks

By Matt Koppenheffer
November 29, 2012

Berkshire Hathaway's (NYSE: BRK-A  ) (NYSE: BRK-B  ) Warren Buffett is seen by many as one of the best investors of our time. But he's also often seen as particularly insightful when it comes to investing in banks.

Certainly Berkshire shareholders should hope that the latter is the case as the company owns 8% of banking giant Wells Fargo  (NYSE: WFC  ) along with $5 billion in Goldman Sachs  (NYSE: GS  ) , nearly $2 billion of US Bancorp  (NYSE: USB  ) stock, and roughly another $1 billion between M&T Bank  (NYSE: MTB  ) and Bank of New York Mellon  (NYSE: BK  ) . Not to mention $5 billion in preferred shares of Bank of America (NYSE: BAC  ) .

So what does Warren know that makes him so prescient when it comes to banks?

1. Owning a bank can be a long-term endeavor.
The banking business is a cyclical one, but bank ownership for Buffett typically isn't. In 1969, Berkshire acquired Illinois National Bank and Trust Company and held onto it until it was forced by regulators to sell the bank in 1980. The company's ownership position in Wells Fargo goes back to 1989, while the stake in M&T Bank dates back to at least 1999.

2. Management matters.
We've seen from the financial crisis how reckless management can lead to outright disaster. When Buffett talks about the banks he's owned, he's generally taking time to praise management. Here's what he had to say in Berkshire's 1990 shareholder letter when praising Wells Fargo's management:

[The team at Wells Fargo pays] able people well, but abhor having a bigger head count than is needed... attack costs as vigorously when profits are at record levels as when they are under pressure. Finally, [they] stick with what they understand and let their abilities, not their egos, determine what they attempt.

3. Leverage kills.
Again from the 1990 shareholder letter:

When assets are twenty times equity-a common ratio in this industry-mistakes that involve only a small portion of assets can destroy a major portion of equity. ... Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices.

4. Panic? Not a chance.
Rather than panic during banking downturns, Buffett has used them to build his ownership stakes. The original stake in Wells Fargo was purchased between late 1989 and early 1990 -- when banks were faltering during the previous banking crisis. During the latest meltdown, Buffett upped Berkshire's ownership in Wells Fargo and US Bancorp, maintained the company's position in M&T Bank, and famously provided preferred-share financing to Goldman. Just last year he sunk $5 billion into Bank of America when it was facing a market freak-out.

The fact that Wells Fargo's price fell after Berkshire initially bought didn't phase Buffett one bit:

Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices. Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude toward market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall. 

In case you're wondering, yes, this is that classic Buffett "be greedy when others are fearful" sentiment.

5. Know where to look for performance.
As Marty Whitman puts it: "Rarely do more than three or four variables really count. Everything else is noise." 

Three things that Buffett has highlighted when it comes to evaluating a bank are: return on assets, risk (leverage ratio), and expenses (efficiency ratio).

6. Remember to own for a long time.
There's no reason to not mention this one twice, because it's an important one. To have a year where an attractive bank he owned made no profit "would not distress us." Instead, "at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity."

7. Pick your spots to go outside the box.
With all of this in mind (especially the risk part), Goldman Sachs may not seem like a very Buffett-esque bank to invest in. And it's really not. However, when we think about the investment banks that Berkshire could have invested in -- Bear Stearns, Lehman Brothers, Morgan Stanley  (NYSE: MS  ) , etc. -- Goldman stands out as head and shoulders above the rest.

Not to mention that Buffett was no stranger to Goldman. In Berkshire's 2003 shareholder letter, you can find Buffett singing the praises of -- believe it or not -- a Goldman Sachs investment banker:

I should add that Byron [Trott] has now been instrumental in three Berkshire acquisitions. He understands Berkshire far better than any investment banker with whom we have talked and – it hurts me to say this – earns his fee.

8. Don't get all mushy over the whole thing.
It's certainly possible to find great banks to invest in and Buffett has found his fair share for Berkshire. But banking ain't an easy slog, and even Buffett will admit he's not going out of his way for a bank unless it's really worthwhile. As he put it: "The banking business is no favorite of ours."

Buffett picks 'em, and you benefit

You can, of course, take the above points and use them to help you find great banks to invest in. Or, you could leave the picking to Warren and simply invest in Berkshire Hathaway. But is now the best time to be buying Berkshire?

http://www.fool.com/investing/general/2012/11/29/8-buffett-secrets-for-investing-in-banks.aspx

Call for more time to 'tweak' Basel III

By Rupa Damodaran
Published: 2012/10/15


Malaysia's top two banks, Malayan Banking Bhd (Maybank) and CIMB Group Holdings Bhd, say the Basel III package of measures to strengthen the global financial system needs more scrutiny and are calling for more time to "tweak" the new regulations.

One of the deepest concerns is that the banking sector could lose investor appeal, Maybank said at the Institute of International Finance annual meeting here.

The Basel III package of measures will see a gradual phase-in of the standards from next year until 2019.

"The consultative papers have been placed with the central banks," said Maybank president and chief executive officer Datuk Seri Abdul Wahid Omar.

Overall, while there are some elements like trade finance and small and medium enterprises (SMEs) that can be tweaked, the banking sector must be prepared for Basel III.

"We saw it as an eventuality and that was why we raised US$1.2 billion (RM3.66 billion) blanket capital to make sure we are prepared," he said in reference to last week's successful completion of a bookbuilding exercise in relation to its private placement.

He called for a level playing field, arguing that the risk weighted assets of European banks are between 20 per cent and 30 per cent, one third that of Asian banks, which measure at between 50 per cent and 60 per cent.

CIMB Group chief executive Datuk Seri Nazir Razak said there are details that need to be looked into as well as Basel III's implications on the banking landscape.

Basel III, he said, is crafted in the context of problems in the West, which is heavily reliant on a global ratings framework that is biased against developing countries.

Nazir said further scrutiny shows that the new regulations will be disadvantageous to Asian banks.

"It places excessive liquidity requirements on Asian banks when there is so much of liquidity in the region and likewise, there is too much emphasis on government bonds when there is enough in Asia."

Smaller banks also stand to suffer as Basel III means heavy compliance costs.

"The West wants to deleverage but Asia has a huge appetite for funds and we need to intermediate that or, otherwise, it will be counter-productive," said Nazir.

Asian banks will need to boost their cooperation and make sure Basel III does not impact their capacity to give out funds.

Australia and New Zealand Banking Group Ltd CEO Michael Smith suggested providing degrees of flexibility (to adopt Basel III), according to the various nations.

Most Asian banks can meet all the targets under Basel III, unlike their European counterparts, some of which will find it difficult to impose the capital requirement.

A more pragmatic approach is needed, he said, adding that the economic structure of Asia is different.

"The sheer amount of liquidity moving around the world due to the monetary easing of central banks in Europe or the United States creates an issue in Asia as investors chase the yields," said Smith.

The shift from Basel 1 to Basel II took 20 years while the shift from Basel II to Basel III took 18 months.

Wahid said Asean, which has set a target to become the Asean Economic Community by 2015, needs to be served by well-capitalised and well-distributed regional banks.

Apart from Maybank, CIMB and Public Bank of Malaysia, there are the DBS Bank, OCBC Bank and UOB Bank from Singapore and the Bangkok Bank of Thailand.

He is looking to Indonesian banks next to expand their reach to other Asean countries.

Read more: Call for more time to 'tweak' Basel III http://www.btimes.com.my/Current_News/BTIMES/articles/20121014225945/Article/index_html#ixzz29sjy9r6D