CHAPTER 2

BANKS

The largest industry group in most Financials sector benchmarks globally is the Bank industry group. It includes both regional and diversified banks as well as Thrifts and Mortgage Finance companies. Since they all tend to act similarly and have similar characteristics, we’ll use the term bank to refer to firms in all of this group’s sub-industries.

As Table 2.1 shows, Banks is a substantial weight in most broad equity benchmarks globally but only a small weight in the S&P 500. This is because despite having the largest domestic banks, “mega banks” like Bank of America, JP Morgan Chase & Co. and Citigroup are technically not in the Bank industry group. They’re considered Diversified Financials companies, and they are very diversified—arguably no single business line is dominant. The same is true in Germany, where Deutsche Bank is also considered a Diversified Financials company. If we add these “banks” back into the industry group, the US weighting looks more like foreign benchmarks at 5.0 %.1

Table 2.1 Bank Weighting Among Benchmarks

Source: Thomson Reuters; MSCI, Inc.,2 S&P 500, and Russell 2000 Indexes. As of 12/31/2011.

Banks, whatever their form, are the lifeblood of most economies—they facilitate the transfer and multiplication of money, payment systems, investment, leverage, etc. Beyond being a vital component of most economies and one of the largest industry groups, banks have several unique characteristics investors should be aware of, from the often confusing nature of balance sheets to robust regulatory requirements. In this chapter, we will discuss:

• Banks 101: What banks are, how they make money and types of banks
• Bank industry group characteristics
• Bank products and services
• Bank regulation

So this book is not as long as Tolkien’s Lord of the Rings trilogy, the focus will be on the basics—by the end, you should know enough to understand how the sector works, but not enough to be a bank examiner or an insurance actuary. The focus of this chapter is on US banks, while also making note of significant differences in foreign markets when appropriate. In general, banks operate similarly across borders, though regulation can vary. Understanding US banking environment basics should provide ample knowledge that can be utilized across borders.

BANKS 101

In this section, we cover the very basics behind banking businesses. What exactly is a bank, and what differentiates it from other financial services firms? How do banks make money, and what different types of banks are there?

What Is a Bank?

Simply, a bank borrows short-term money (deposits) and makes longer-term investments (loans and securities). In doing so, banks transfer money from savers to investors (or spenders). A bank traditionally earns its income from the spread between the cost of funds (deposits) and the return on assets (loans and securities).

Banks are simply big balance sheets. Therefore, managing the balance sheet is of the utmost importance. Aligning liabilities with assets and capital buffers with growth, taking appropriate credit, interest rate and currency risk—these are all things banks need to manage on a daily basis.

In the US (and most other major countries), the banking system is a fractional reserve banking system. This means banks take in deposits but retain only a fraction of them as a reserve. The amount banks must retain—i.e., have set aside to cover their deposits—is called the required reserve ratio (RRR). In the US, the ratio is 10% for retail deposits3 (several nations’ RRRs are shown in Table 2.2)—which means for every $100 in deposits, a bank must have $10 in reserve. This reserve can be in a vault or deposited at the central bank (in the US, the Federal Reserve). While the idea of an RRR is very common, there are often nuances making each calculation a bit different—for example, in the US, the RRR is calculated using “on demand” deposits, making term deposits reserve-less.

Table 2.2 Global Required Reserve Ratios

Source: International Monetary Fund, “Central Bank Balances and Reserve Requirements” (February 2011) (accessed 03/27/2012). EMU and Taiwan data from respective central banks, as of May 2011.

Notes: Ranges are sorted by the top of the range.

The rest the bank can use to make investments—e.g., making a loan or purchasing a security. This allows deposited money to be multiplied in an economy.

Money Multiplication

Money multiplication is essential to a healthy, growing economy. But what does that mean? Part of the 90% banks may invest (e.g., through loans or purchasing securities) may eventually make it back to a bank in the form of deposits. Then, the bank again retains 10% and re-invests the money. This can happen over and over until the limit set by the reserve requirement.

Figure 2.1 shows different reserve requirements’ hypothetical impact on an initial $100 deposit. Using a 10% RRR, a bank can multiply money significantly—to nearly 10×, but just as Achilles never catches the tortoise, a 10% RRR mathematically never allows a 10× multiple. Following the same $100 through just three deposit cycles shows banks can turn $100 into nearly $350. The higher the RRR, the lower the multiplier. Some central banks actively use the RRR as monetary policy, hiking the requirement to tighten, and vice versa. This can allow for a form of regulatory arbitrage, so it is important to understand central bank policies when investing in banks.

Figure 2.1 Money Multiplier

Multiplication only happens if banks are active in their lending or investing activities. If a bank takes the $100 deposit and puts the entire amount in a vault, the $100 is essentially taken out of the system—it doesn’t get lent out and re-deposited. This is what happened in the wake of the 2008 financial panic—bank reserves swelled, but lending activity remained muted, so money wasn’t moving through the economy. Figure 2.2 shows even while bank reserves (as illustrated by M0) surged, the lack of multiplication suppressed broader money supply growth (as illustrated by M2).

Figure 2.2 Money Supply

Source: US Federal Reserve, as of 12/31/2011.

How Do Banks Make Money?

Banks earn revenue from two main sources: net interest income and non-interest income.

Net Interest Income (NII)

Net interest income is the total of interest earned on earning assets—like a loan or investment securities—minus the interest costs associated with funding these assets. A common metric used in banking is the net interest margin (NIM), which is the interest earned on earning assets minus the interest paid on sources of funding, measured as a percentage of earning assets. For example, a bank with earning assets of $1,000 yielding $50 with funding costs at $20 would have a net interest of $30—or a NIM of 3%.

A bank’s NIM is driven by many factors, including the level of interest rates, the yield curve and the supply and demand for credit. Both sides of NIM—interest income and expense—are highly correlated to the level of intermediate-term US Treasury yields and to that of the effective US federal funds rate. The federal funds rate can be used as a proxy for a bank’s cost of funds, while the Treasury yield can be used as a proxy for yield on earning assets. So shifts in the yield curve spread can drive bank NIM—up and down.

Shifts in supply and demand also impact banks’ NIM. As borrowers demand more lending, banks can support higher margins. Conversely, if supply of funds outstrips demand, margins get pinched. (The Fed tracks supply and demand for credit via its quarterly Senior Loan Officer Opinion Survey [SLOOS]—available on its website.)

The mix of earning assets is also an important driver of NIM. For example, a shift from traditional residential mortgage lending into more aggressive construction/development lending can improve yield in the loan portfolio. A shift in the securities portfolio from US Treasury securities to municipal bonds can do the same. However, banks must be careful they don’t increase their risk profile too much as it could drive up funding costs (and narrow the NIM) if investors start worrying about banks’ risky exposures. Likewise, a shift in funding sources can impact NIM. If a bank can attract more non-interest deposits, margins could improve as funding costs move down.

In the US, net interest income averaged 65% of revenue from 1984 to 2011. However, until the 2008 financial crisis, the industry increasingly focused on increasing fee income, which moved this ratio from over 70% in the 1980s to less than 60% in the 2000s (see Figure 2.3). Following the crisis, banks reverted to focusing on traditional banking (of their own accord and due to regulatory interference), thus making net interest income a growing component of revenue. While most banks earn more from interest than non-interest sources, the degree of exposures can help in determining a bank’s relative interest rate sensitivity. Banks with less exposure to interest income sources can be less sensitive to interest fluctuations.

Figure 2.3 Net Interest Income as a % of Revenue

Source: Federal Deposit Insurance Corporation, “Quarterly Income and Expense of FDIC-Insured Commercial Banks and Savings Institutions,” as of 12/31/2011.

Non-Interest Income

Non-interest income is income from non-interest bearing sources. The largest sources include services charges on deposit accounts, trading account gains and fees, fiduciary activities and net servicing fees. Other sources include revenue from non-banking sources such as investment banking, brokerage, insurance commissions or even venture capital revenue. Many of these revenue sources, like insurance and investment banking, are further explained in subsequent chapters.

The Efficiency Ratio

Beyond revenue sources, banks are very focused on the efficiency ratio—i.e., non-interest expense to revenue. It measures how much cost is associated with every unit of operating revenue. The lower the ratio, the more efficient the bank.

Large banks tend to believe banking services are commoditized, so they focus on expenses and try to maintain a low efficiency ratio. Smaller banks usually attempt to enhance the customer experience, which comes at a cost, and typically have higher efficiency ratios. In 2010, US banks on average had an efficiency ratio of 61%—big banks reported 59% and small banks reported 72%.4

A common M&A strategy is matching up a highly efficient bank, which supports a low efficiency ratio, with a bank with a relatively high efficiency ratio. The intended result would be synergies from implementing cost-saving initiatives in the acquired bank.

Credit Quality

Credit quality, or asset quality, typically refers to the payment trends (or the expected payment trends) on a loan portfolio. The more loans going sour (or even the more loans expected to go sour), the lower the credit quality.

There are many ways to gauge credit quality: a portfolio’s average FICO score, the average loan to value, average debt to income on the loans or even the structure of a portfolio (Alt-A versus 30-year fixed mortgage). To a bank, the credit quality dictates how the portfolio is likely to react to certain economic environments—which helps determine the likely portfolio yield. If you have a pool of high-yielding, low credit score credit card loans, you would anticipate greater losses in an adverse economic scenario. The trade-off is higher yield now in exchange for the risk of higher potential credit losses later.

Same goes for Banks investors. When selecting a bank stock, one way to gauge a bank’s relative riskiness is by looking at its loan portfolio’s risk profile. Are they construction loans, commercial and industrial loans, mortgages or credit cards? It can make a difference, which Figure 2.4 shows. Note how the past-due rate on commercial and industrial loans is much less volatile than it is on construction and development loans.

Figure 2.4 FDIC 30–89 Day Past Due Rate

Source: Federal Deposit Insurance Corporation, “Quarterly Loan Portfolio Performance Indicators, All FDIC-Insured Institutions,” from 12/31/1991 to 12/31/2011.

If you decide the bank has a strong loan portfolio, it could also mean it is a strong bank (of course, other things like capital and liquidity should also be considered). Sometimes this is good, sometimes bad. A strong bank doesn’t always outperform a weak bank (i.e., low credit quality loans), or vice versa, but in certain market environments, one likely has the advantage. If credit quality is broadly deteriorating, the strong bank likely has the tailwind. However, if the environment is improving, the “weak bank” could witness greater return for taking the additional risk.

Monitoring key credit metrics such as the NPL ratio, NPA ratio, NPL coverage ratio (definitions to follow) and allowance-to-loans ratio is critical to understanding a bank’s credit quality. When monitoring these credit metrics, it is best to pay attention to the bank’s underlying quality while also comparing it to peers.

Here are a few commonly used metrics:

• The NPL ratio (non-performing loans/total loans) portrays loan portfolio quality—typically includes loans 30–90 days delinquent.
• The NPA ratio (non-performing assets/total assets) portrays asset quality, including loans and other securities.
• The NPL coverage ratio (loan loss reserve/non-performing loans) reveals how much a bank has set aside to cover non-performing loans if it charges them.
• When a loan moves to nonaccrual status, it has typically been delinquent for some time. At that point, interest is not accrued on the loan, and a realized loss is likely inevitable.
• A net charge-off represents the realized loss a bank takes on a loan. This number is net of “reversals,” which occur when previously sour loans become good.
• The allowance ratio (loan loss reserve/total loans) gives insight into how much capital is set aside to cover losses stemming from a bank’s total loan portfolio.
• A commonly used measurement of strength is the Texas ratio (non-performing assets/core equity). This scales a bank’s non-performing loans to its available capital. If a bank has more non-performing loans than it does capital, this could be cause for concern.

Asset or Liability Sensitivity

When a bank is “asset sensitive,” its assets are more sensitive to interest rate fluctuations than its liabilities, as opposed to being “liability sensitive.” If prevailing interest rates rise, an asset-sensitive bank would see its assets “re-price” quicker than its liabilities, and it would thus benefit from the move in interest rates. A bank with adjustable-rate loans funded by long-term fixed-rate bonds would be a simplistic example of an asset-sensitive bank—the interest income on the loans would increase before the interest cost of the long-term bonds does, which would allow for a widening margin. A bank funding a 10-year fixed-rate mortgage with short-term deposits would be an example of a liability-sensitive bank.

Most banks attempt to match asset and liability sensitivities (adjustable versus fixed, short versus long) so the net impact is not extreme in either direction, but even a small bet in either direction often gives a bank an edge over competition. A bank with the correct sensitivity will have a tailwind relative to peers—so be sure to consider your interest rate forecast and a bank’s interest rate sensitivity when selecting a bank to invest in.

Financial Services Have Been Commoditized

In the developed world and a few developing countries, banking has become largely commoditized—meaning what you can get at one bank, you can essentially get at another, likely at a very similar price. This makes pricing powers much lower now versus a few decades ago. As a result, banks have been known to attempt personalizing the banking experience or offering businesses incentives—while receiving a free toaster for opening a checking account hasn’t been common for some time, various incentives for starting or expanding a relationship with a bank are.

TYPES OF BANKS

There are many types of banks globally—construction banks, regional banks, money center banks, diversified banks, thrifts, savings and loans (S&Ls), development banks, central banks, Islamic banks . . . on and on. GICS segments the industry group into Commercial Banks and Thrifts & Mortgage Finance companies, but considering the very small presence of Thrifts & Mortgage Finance companies and for simplicity’s sake, we’ll focus on Commercial Banks, which can be further categorized as Regional and Diversified Banks.

Regional and diversified banks are very similar—size and geographic presence aside. Diversified banks are commercial banks (as opposed to investment banks) whose businesses are derived primarily from commercial lending operations and have significant business activity in retail banking and small and medium corporate lending. Regional banks are effectively the same, though typically smaller and operating in a limited geographic region, like a single city or county. Outside the US, regional banks may focus on an individual country or a specific jurisdiction within the country. For example, in Japan, the big city banks (which are considered Diversified Banks) focus on the major metro areas in Japan, as well as perhaps some overseas exposure, while many regional banks in Japan typically focus on one prefecture and surrounding areas.

Regional banks can be very small, or they can be quite large. In the US (as of this writing), the smallest reporting publicly traded regional bank had total assets of $1.7 million, while the largest had assets of $271 billion.5 As banks increase in assets, they may be referred to as “super-regional banks,” which, while not recognized by GICS, can be defined as multistate regional banks with assets large enough to be ranked as one of the 100 largest banks in the US.

Beyond becoming a super-regional bank, as banks grow in size and breadth, they can be considered money center banks. These banks are larger banks typically located in major financial hubs, and they offer banking services to private and public markets, including other financial institutions nationally, as well as in foreign markets.

Table 2.3 lists the world’s largest banks, measured by assets. Note the absence of US banks. Table 2.4 lists the largest US banks—Wells Fargo ranks seventeenth globally based on total assets. (Remember, JP Morgan Chase & Co., Bank of America and Citigroup are not classified as banks. If they were, they would be ranked first, second and third domestically and eighth, tenth and twelfth globally, respectively.6)

Table 2.3 World’s Largest Publicly Traded Banks

Source: Bloomberg Finance L.P., as of 12/31/2011.

Table 2.4 America’s Largest Publicly Traded Banks

Source: Bloomberg Finance L.P., as of 12/31/2011.

Table 2.5 briefly describes various categories of banks—which should be considered when deciding where to invest. For example, if you think the commercial & industrial (C&I) lending environment is going to be stronger than expected (due to stronger demand and better credit trends, perhaps), then it may behoove you to consider a regional bank over a savings bank or thrift due to its focus on C&I lending.

Table 2.5 Types of Banks

BANKS INDUSTRY GROUP CHARACTERISTICS

The Banks industry group tends to be event-driven—relative performance is a function of economic, political and sentiment events, rather than consistently outperforming or underperforming during specific market cycles. In recent decades, the S&L crisis, Asian Contagion, Tech crash, real estate boom and credit panic can explain much of the group’s relative performance. In other words, this group can outperform (or underperform) during bull markets or bears, recessions or expansions—making it a difficult group to predict.

There are, however, certain characteristics that hold true over time: Size wise, it is market-like, it tends to be more value than growth, returns are often volatile and it is economically sensitive.

Size: Banks Is Market-Like

Banks, like the broader Financials sector, is market-like in size (i.e., market capitalization), if not a tad big at first glance. However, there is no discernible pattern of relative outperformance or underperformance during periods of big cap or small cap dominance. Currently, Banks’ average size in the MSCI World index is $20 billion, a bit higher than the $16 billion of the broader index.7 The median size is just a bit higher than the broader index at $8.4 billion—meaning roughly half of the banks in the index are bigger and half are smaller than the median of the broad index.8 Conversely, the weighted average market capitalization of the MSCI World tells us a different story—measured this way, Banks is considerably smaller than the market.9

The big-but-small nature of the industry group is one reason Banks does not tend to follow big versus small market cycles.

Style: Banks Are Value

Banks tend to trade at low valuations, tend not to be seen as “big growth” and often pay sizable dividends—so Banks tends to perform better when value stocks overall outperform broader market indexes.

Book Value

Price to book is a very common metric used when valuing a bank as it is more stable than earnings- or revenue-based metrics. It compares a company’s book value (or “net worth”) to its market capitalization. A bank with a net worth of $10 billion and a market capitalization of $15 billion has a price to book of 1.5.

Price-to-book ratios vary over time, and at the time of this writing, Emerging Markets banks trade at a premium to developed world banks—mostly due to higher growth rates and profitability (see Figure 2.5).

Figure 2.5 Price to Book Comparison

Source: Thomson Reuters; MSCI, Inc.,10 as of 01/31/2012.

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Furthermore, Banks historically has a higher dividend yield than most other industry groups across all sectors. Banks investors often covet dividends and use bank stocks to generate consistent cash flow over time. (Investors should remember dividends can and do get cut. In fact, many banks cut dividends in 2008 and 2009 during the credit crisis and its aftermath—and, at the time of this writing nearly four years later, banks still haven’t restored dividend payouts. Remember: A dividend is not guaranteed cash flow.) From 2004 to 2011, and despite government interference, US Banks’ average dividend yield of 3.0% put it in the top five dividend-paying industry groups and was much higher than the S&P 500 index’s average dividend yield of 2.0%.11 In the five years prior to the credit crisis (2004–2008), the banking industry had the second highest dividend yield, nearly twice that of the average industry.12

Why do banks tend to pay higher dividends? Since banks try to maintain the lowest possible cost of capital over time, paying a dividend can help attract longer-term investors—those focused on cash flow rather than growth prospects. A stable, long-term investor pool can allow banks to better forecast and control weighted-average cost of capital (WACC) and therefore maintain more consistent margins. Additionally, considering many developed-world banking environments are traditionally lower growth, dividends are a way for banks to shed excess capital and improve return on equity (ROE) by reducing the denominator side of the equation at regular intervals.

Banks Can Be Volatile

Since Banks is, by its very nature, more leveraged than any other industry group, it can be more volatile (see Table 2.6). A slight change in asset pricing (like the value of a mortgage-backed security) can have tremendous impact on a bank’s capital positioning and profitability. A recent example was the horrendous impact of mark-to-market accounting rule FAS 157 (fair-value accounting) during the 2008 credit panic. Banks were forced to mark down assets based on pricing found in illiquid markets. Prices for certain assets were artificially depressed, which devastated bank balance sheets. Shares responded accordingly and plummeted during the downturn, just to spring higher after FAS 157 was watered down in March 2009.

Table 2.6 MSCI World Industry Group Volatility: Standard Deviation (Rolling Years, 1994–2011)

Source: Thomson Reuters; MSCI, Inc.,13 as of 12/31/2011.

Banks’ leveraged nature, their sensitivity to regulatory whims and reliance on other people’s money are why the Banks industry group is more volatile (as measured by standard deviation) than 18 of 24 standard industry groups.

But just like most things, the industry’s volatility ebbs and flows. Much of the volatility since 1994 can be attributed to a few periods of heightened volatility: the aftermath of the Asian Contagion and the 2008–2009 financial crisis.

Banks Are Sensitive to Certain Economic Conditions

Banks are sensitive to economic conditions, but a few items stand out: interest rates, residential real estate and employment trends. Each of these can impact a bank, whether by changing supply and demand dynamics or impacting credit quality. In general, stable interest rates, a positively sloped yield curve, stable or rising home prices, increasing housing turnover and falling unemployment would provide banks substantial tailwinds.

Interest rate trends impact the cost of funds and yield on earning assets—which ultimately drive banks’ margins. They also impact credit demand—a low interest rate environment encourages borrowing. As important as the shape and location of the yield curve, interest rate volatility is a headwind as widely swinging interest rates make it more difficult to manage a bank’s balance sheet and maintain appropriate exposures.

Residential loans account for 33% of US bank loan portfolios, or 18% of total bank assets, making this category the largest single asset in the banking system (Federal Reserve Flow of Funds, Q4 2011 12/31/2011). Therefore, residential real estate market trends can greatly impact a bank’s profitability—and, by extension, whether investors are inclined to pay a higher or lower price for the bank’s stock. Periods of stable or rising home prices mean mortgages are likely to continue performing—this is a positive, or at least neutral, factor for banks. Periods when foreclosures are markedly higher mean banks risk greater losses in their mortgage portfolios, which can be a decided negative.

Moreover, the residential lending market accounts for a similarly large portion of bank income. The more loans a bank can underwrite, the better—spreads, fees and points all play a part, and this source of income is tied to loan volume.

Employment trends are also very important to most banks—they drive consumer spending, saving, delinquencies and borrowing. A high unemployment rate can bring higher credit costs for banks. It will also pressure spending and thus can reduce borrowing—all negatively impacting banks. As the unemployment rate falls, credit losses typically fall, spending improves and lending picks up. Remember, the absolute unemployment rate is not that important—focus rather on the trend relative to expectations.

BANK REGULATION

Core drivers for all sectors, industries and companies are the same—everything can be categorized as either an economic, sentiment or political driver. How impactful each is naturally differs. The banking industry happens to be heavily influenced by political interference—primarily in the form of regulation. While the US industry is not controlled to the extent of regulated utilities, for example, recent regulatory reform is moving it in this direction. And in some countries (like China) that distinction between industries is smaller.

In the developed world, core bank regulators tend to be central banks or financial services authorities—government authorities that implement and enforce rules typically set by politicians. This makes the industry highly sensitive to political noise. Most bank regulation can be categorized as capital controls, liquidity requirements, consumer protection or structural requirements.

Given the impact politics and regulations have on banks, it’s important to stay on top of current legislation as much as possible—a challenge, given its fluidity. However, a fundamental understanding is critical, so we’ll touch on a few core concepts.

The Basel Committee

Ten central bank governors established the Basel Committee in 1974 in an effort to harmonize global bank regulation. Though it lacks formal supervisory authority or legal force behind its recommendations, in 1992, the committee established the Basel Capital Accord, which outlined a credit risk measurement framework and 8% minimum capital standard—it was subsequently adopted by both members and non-members. In 1999, the committee proposed changes to the framework, which came to be known as Basel II and provided a foundation for national rule making.

Basel II was based on a three-pillar framework of minimum capital requirements, a supervisory review process and market discipline. In the 2008 financial panic’s wake, the Basel Committee again made changes, resulting in Basel III—which focuses on capital definitions, capital conservation buffers, countercyclical buffers, leverage ratios and global liquidity standards, among others.

A high-level understanding of the Basel Accords is critical to any bank investor, and while a full explanation is beyond this book’s scope, we attempt to outline some of Basel III’s major aspects here. (For more detail, refer to BIS.org.)

Definition of Regulatory Capital

Bank regulatory capital can be broken into a few core components: Common Equity Tier 1, Tier 1 and Tier 2 capital. Simply, Common Equity Tier 1 and additional Tier 1 are going concern capital, while Tier 2 capital consists of more debt-like capital and is considered gone concern capital. Whereas going concern capital can absorb losses while the bank is a going concern, gone concern capital absorbs losses only after a bank fails. Consider the difference between holding equity (shares) and debt (bonds): Banks’ losses would detract from shareholders’ equity, but bondholders would eventually get their money back unless there was a default.

As of this writing, Basel III set minimum capitalization ratios (the ratio between the equity level and risk-weighted assets) for Common Equity Tier 1, Tier 1 and total capital at 4.5%, 6.0% and 8.0%, respectively.

Risk-Adjusted Balance Sheets

Many regulatory capital ratios, such as the Tier 1 capital ratio, rely on risk-adjusted assets rather than total assets. In the US, this means many regulatory capital ratios are based on $9.4 trillion (risk adjusted) rather than $13.8 trillion (total assets).14 The premise behind risk adjusting a balance sheet is some assets are simply riskier than others—some have a much higher probability of default (POD) and/or higher expected recovery values. Consider the difference in credit risk between a US Treasury security, a pool of residential mortgages and a pool of credit card loans. The Treasury has the full faith and credit of the United States of America, which is the safest of the three. Mortgages tend to be higher quality than credit cards not just because the borrower often has a vested interest in paying the mortgage, but also because of the collateral—the underlying real estate has value, and if the mortgage defaults, the lender is only on the hook for the difference between the mortgage loan and the property value. The credit card is not “collateralized” and therefore is the riskiest of the three.

As a result, the Treasury will have the smallest risk weighting, followed by the mortgage then the credit card. And since each of these exposures has significantly different risk, the capital required for each is different—the same capital ratio is required for each, but it is based on the risk-adjusted value of the exposure. (See Appendix C for more detail on risk weightings.)

Capital Conservation Buffer

Basel III introduced a capital conservation buffer of 2.5% over and above minimum capital requirements, bringing the required Common Equity Tier 1, Tier 1 and total capital ratios to 7.0%, 8.5% and 10.5%, respectively. The buffer’s intent is to protect depositors as opposed to shareholders in the event a bank lends beyond minimum capital requirements. As a bank’s capital ratio falls below its required buffer, it must increasingly restrict distributions, which determines how much of earnings the bank must conserve the following year.

Countercyclical Buffer

Basel III also introduced a countercyclical buffer that aims to ensure capital requirements account for macro-financial economic conditions. In other words, this buffer adds up to an additional 2.5% to minimum capital ratios in the event countries believe aggregate credit growth is excessive.

Leverage Ratio

As opposed to other capital ratios that use a risk-adjusted balance sheet, the leverage ratio (which is being tested at 4% from 2013 to 2017) compares Tier 1 capital to total assets and would limit outright bank leverage regardless of how much risk it takes. This could negatively impact more conservative banks because near credit risk-free investments would receive the same weight as high-risk investments.

Global Liquidity Standards

The liquidity coverage ratio (LCR) is expected to be implemented by mid-2013 and is designed to prevent bank runs by ensuring banks have sufficient unencumbered, high-quality assets. So while a bank run likely conjures scenes from It’s a Wonderful Life for most, banks today back assets with more than just deposits.

The LCR mandates the total of high-quality liquid assets must always exceed total net outflows over the next 30 days—in other words, it ensures banks always have enough cash equivalents to support total cash needs for the next 30 days.

On the other hand, the net stable funding ratio (NSFR) focuses on longer-term funding profiles in an attempt to reduce reliance on short-term funding. Considering the highly debated costs of the ratio, the NSFR has been pushed off to 2018.15

As it stands now, the committee wants Basel III to be implemented in stages, as illustrated in Table 2.7.

Table 2.7 Basel III Implementation Timeline—Phase-in Arrangements

Source: Bank for International Settlements, as of 12/2011.

Shading indicates transition periods. All dates are as of January 1 .

National regulators will set their own rules and determine their own timelines, though often based on the committee’s recommendations. This can allow for regulatory arbitrage while certain countries’ banks have a relative advantage over global peers.

Liquidity

Since banks are in the business of borrowing short and lending long, their liquidity (or their ability to meet current obligations) is more important than firms’ in any other industry group.

The banking system is built upon trust: Depositors trust banks to return deposits upon demand, and banks trust other financial institutions in the same way. If this trust is broken or doubted, banks’ funding sources could become much more expensive or even dry up, like in 2008. Bank deposits, traditionally a core funding source, are usually insured to a degree, but other forms of funding are not—typically referred to as “wholesale funding.” Wholesale funding is derived from other financial institutions—like borrowing from a bank, borrowing in the repo or commercial paper markets or even borrowing directly from a central bank or other government entity.

Deposit Funding

Thanks to financial innovation over the decades, banks have come to rely less on deposits as a core funding source. From 1984 to 2008, deposits went from 85% of liabilities to just 71%.16 Following 2008’s financial panic, deposits surged to 80%, reversing a nearly two decade-long trend in about a year (see Figure 2.6). Deposits’ stability coupled with many wholesale funding sources’ seizing up drove much of the rapid shift. Bank regulation changes and fears of future changes also contributed.

Figure 2.6 FDIC Banks’ Total Deposits as a % of Total Liabilities

Source: Federal Deposit Insurance Corporation, “Quarterly Banking Profile,” as of 09/31/2011.

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Interbank Lending Rates

Interbank lending is the industry’s lifeblood, allowing banks to manage liquidity needs daily and central banks to implement monetary policy.

Uncollateralized interbank lending is just what it sounds like: One bank lends to another on the borrowing bank’s word and the loan will be repaid with interest at the scheduled maturity date. These rates are not set by any governing body, but typically a central bank’s target rate will provide the foundation for overnight rates. These reference rates are expected to portray perceived borrowing rates between banks on an uncollateralized basis over multiple maturities in specific currencies and markets—this is not the rate at which banks actually borrow, but rather the rate at which banks expect they would borrow if the need arose. Interbank offered rates (IBOR) are reference rates set by a panel of banks operating in a specific market—e.g., LIBOR in London, the EURIBOR in Europe, TIBOR in Tokyo and SIBOR in Singapore—each similar but using its own methodology.

The reference rate is an annualized rate, so if the overnight EURIBOR is at 1.0%, this means an overnight loan would cost 0.0027% (1.0%/365 days). Which might sound cheap, but for a bank borrowing €25 billion for one day, it would equate to €684,931.51.

Liquidity can be measured various ways. The loan-to-deposit (LDR) ratio compares total deposits to total loans and demonstrates how much of a bank’s loan portfolio is funded with deposits rather than other sources. A ratio lower than 100% indicates the bank funds its entire loan portfolio via deposits—meaning that bank would likely be less impacted by trends in wholesale funding markets. When liquidity is scarce (or expensive), a low LDR can be a significant advantage.

Other measurements are the core funding ratio or the non-interest-bearing deposits ratio. Core funding refers to funding from retail deposits—which tend to be more stable funding. Non-interest-bearing deposits (typically traditional checking accounts as well as some escrow or payroll accounts) can help margins—the more the better.

All of these ratios give insight into a bank’s liquidity profile. For example, if you are looking for a bank that may not be impacted by liquidity concerns, you may focus on low-LDR banks with high core deposit ratios. Or if you think short-term interest rates are likely to rise and potentially pressure margins, banks with ample non-interest-bearing deposits would have a leg up.

Notes

1. Thomson Reuters, as of 12/31/2011.

2. MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages.

3. International Monetary Fund, “Central Bank Balances and Reserve Requirements” (February 2011) www.imf.org/external/pubs/ft/wp/2011/wp1136.pdf (accessed 03/27/2012).

4. Federal Deposit Insurance Corporation, “Quarterly Banking Profile,” as of 12/31/2010. Big assets = >$10b and small = $100m–$1B.

5. Bloomberg Finance L.P., as of 12/31/2011.

6. Ibid.

7. See note 1.

8. Ibid.

9. Ibid.

10. See note 2.

11. Thomson Reuters, from 12/31/2004 to 12/31/2011.

12. Ibid.

13. See note 2.

14. Federal Deposit Insurance Corporation, as of 12/31/2011.

15. Bank for International Settlements, “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (December 2010, rev. June 2011), www.bis.org/publ/bcbs189.htm (accessed March 28, 2012).

16. Federal Deposit Insurance Corporation, “Quarterly Banking Profile,” as of 12/31/2010.