If you have been following the news recently, you may have heard that Credit Suisse, the 166-year-old Swiss bank, just failed and got bailed out by the Swiss government and UBS. Previously, several banks in the United States also failed, starting from Silvergate Bank, Silicon Valley Bank, and Signature Bank. Many other US regional banks are also in trouble, with their stocks plummeting following the fear of massive bank runs nationwide. A banking crisis is upon us. As the popular wisdom says: “Buy when there’s blood in the streets, even if the blood is your own”; should we invest in banks? Let’s look at this banking sector to understand what risks we are dealing with.
Bank Failure: Who Gets Paid First?
Bank failure is rare, but this has happened regularly over the years. During the 2008 Global Financial Crisis, large banks such as Washington Mutual, Lehman Brothers, and Bear Stearns collapsed one after another. In the first quarter of 2023 alone, we have seen several bank failures across US and Europe. So what happens when a bank fails? Who gets paid first?
Depositors vs. Bondholders vs. Shareholders
In the most simplified way, this is usually the precedence of claim in the case of a bank failure:
Depositors
Almost all of us have money in a bank. We are the depositor in this case. Depending on the country, depositors are insured up to a certain amount, for example, $250,000 in the US and $75,000 in Singapore. If your deposit is within the insured amount, you will get 100% of your money back.
How about if I have more than the insured amount? You are not guaranteed anymore, but you are up on the list. You get paid first when the bank assets are sold and distributed. Your chance of recovering most of your deposits is good, assuming the bank failure was due to a liquidity issue, not fraud.
If you want to be safe, keep only up to the insured amount in one bank and diversify across multiple banks.
Bondholders
Bank issues bond. If you hold bank bonds, you are next in line for the payout in case of bank failure. There are several types of bonds with different priorities; for example, the AT1 bond is the last among the bondholders to receive the payout.
In the recent banking crisis, most bondholders got wiped out after the collapse. This serves as a reminder to bond investors because although the risk is low, your principal is not guaranteed. In our view, we prefer to only hold bonds from the strongest of the strongest banks, or we usually call it ‘too big to fail.’
Shareholders
If you buy bank stocks, you are in this category. You are the last in line to get the payout. Even before the bank collapsed, the share price would have been hit hard because the market is forward-looking and starts pricing the potential collapse. Your chance of recovering your money is not good in this category. Due to this risk, most investors sell their holdings upon the first sign of trouble.
In the recent banking crisis, we saw that shareholders were wiped out upon collapse. Again, we prefer to invest only in the strongest banks to minimize this risk.
Now that we know shareholders are likely to get wiped out upon a bank failure, this does not mean we should not invest in the banking sector. Some of the strongest banks can outperform the general market index.
This banking crisis may provide us with an excellent opportunity to acquire the shares of the best banks at a discounted price. The critical thing here is to minimize our risk when investing in the banking sector. What are some risk considerations we can look for when researching a bank?
Risk Metrics for Bank Stocks
Some banks will fulfill some of these criteria but remember that we only want the strongest of the strongest; thus, they ideally should pass all of these metrics.
Reputation
As silly as this sounds, reputation matters in the banking sector. No bank can survive a bank run. The current banking system works by only holding around 10% of the total customer deposits in liquid assets while the rest are deployed elsewhere. This is called fractional reserve banking. The premise is that there wouldn’t be a need to serve withdrawals exceeding the liquid amount at any time. Well, yes, in most cases, but as soon as a bank run happens, this won’t hold anymore. No banks will survive a bank run.
How to avoid bank runs? Reputation. The impression that the bank is the safest, most well-managed, too-big-to-fail bank in the nation will make people feel confident that their money will be there even during financial distress. Reputation matters.
For example, would you trust a bank already in decline with this kind of reputation?
Revenue and Net Income
Again this may sound obvious, but we only want to invest in profitable banks. To be more stringent, we only consider the banks that have been able to grow their revenue and net income consistently over the past several years. Look at the following examples, and decide for yourself which you would prefer to invest into:
As you can see from the two charts above, DBS Bank Singapore has consistently grown its net income over the past decade, while Credit Suisse has been on a bumpy roller coaster ride between profit and loss.
From the investing perspective, we track profitability by looking at Return on Equity (ROE). ROE is simply net income divided by shareholders’ equity. This measures the profitability of a company. We usually like to see a minimum ROE of 9%. For example, DBS Bank ROE currently stands at 15%, an impressive number.
Liquidity
What’s the biggest risk faced by a bank? Bank run. To project confidence, the bank must ensure having enough liquidity to cover all customers’ withdrawal requests if needed. There is a metric we can look at to make sure there is reasonable enough liquidity to cover this risk: Liquidity Coverage Ratio (LCR). LCR is the banks’ high-quality liquid assets divided by the total net cash outflows over 30 days. The higher number, the better. We need at least >100% for this metric. We want to ensure the bank can serve withdrawal requests for >30 days under normal circumstances (assuming no bank run). For example, DBS Bank Singapore has an LCR of 133% as of Sep 2022.
Distribution
When banks receive your deposit, they need to lend out or invest it somewhere to earn some interest so that they can pay some back to you. Where they put your money to work matters, so as a measure, we look at the Loan-to-Deposit Ratio. Loan-to-deposit ratio is the bank’s total amount of loans divided by the bank’s total amount of deposits over the same period as a percentage. This shows whether the banks can effectively distribute the deposits into loans.
If this number is too high, the bank may not have enough liquidity because it loans more than it receives. A low number is also not good because it implies the bank cannot efficiently lend the money; thus, it usually ends up parking the deposits into government securities. Investing too much into government securities may expose the bank to interest rate risk. If the interest rate rises, the security price will decline. If the bank needs extra liquidity, it must sell those securities at a loss.
This is what happened with the Silicon Valley Bank (SVB), where they invested too much of their deposits into the US Treasuries and MBS. For example, SVB has a loan-to-deposit ratio of 43%, while DBS Bank Singapore has a loan-to-deposit ratio of 81%. This ratio shows that SVB was inefficient in distributing loans compared to DBS. We usually look for a loan-to-deposit ratio of around 50-90%.
Loan Default Risk
That said, being able to loan out the deposits does not always mean a good thing. What if the loans are of low quality and most go into default? Another equally important metric is the Non-Performing Loan Ratio (NPL). NPL is the non-performing loan divided by the overall loan portfolio as a percentage. The smaller number, the better. For example, DBS Bank Singapore has an NPL of 1.1%, a healthy number.
Banking Crisis: Should we invest in bank stocks?
Considering they pass all of the risk criteria above, the basic principle of investing still applies: invest only when the stock is undervalued. This applies whether or not we are in a banking crisis.
How should we value a bank stock? There are many ways to value a bank stock, but we would like to propose our favorite one: Price-to-Book value (P/B). P/B is the ratio of the bank’s share price over its book value per share. Don’t worry; you don’t have to calculate this yourself. Most investing tools already have this data available for you.
To know if a share is undervalued, we want the current P/B ratio to be below its historical average. For example, DBS Bank Singapore currently has a P/B ratio of ~1.6, while its historical average over the past five years is ~1.3. This implies DBS share price is not undervalued at the moment, and we would not be interested in acquiring more shares at this price. You can apply a similar analysis to other banks to find potentially undervalued ones.
The current banking crisis may provide us with the opportunity to invest in some of the best banking stocks in the world. The key is to be patient and wait until the share price is undervalued (or at least fairly valued) before investing. If that opportunity never comes, no worries; there are always other opportunities elsewhere. Happy investing.
