This is a primer for some Quickies about Banks, getting a general understanding of the banking industry …
This is not investment advice. Please read the disclaimer.
Part 1 of a series on banks: First, I am going to write about banks’ business in general and current issues. Then I take a look at a few individual non-mainstream banks with different and individual profiles (some might surprise you). Last, I will tell you which bank I deem to be the most attractive investment.
The traditional business model of banks
is was quite easy and could have been summed up as 3-6-3. The meaning of 3-6-3 was you give customers 3% for their money (short(er) term deposits), you offer them longer-term loans for 6% and you are at the golf course at 3pm*. That pretty much describes the main purpose of banks. Additionally, using transaction banking services customers can transfer their e-money to any other bank account or shop with it using a banks’ plastic card. This old and easy business model solved a lot of problems. A few banks could collect all the deposits from savers and lend it to all the consumers and corporates in need of a loan (reducing search costs and contact nodes on both sides, reducing risk for savers).
I knew about the 3-6-3 banking model long before reading it on net interest‘s article The End of Banking which I highly recommend you to read!
Many bankers do not play golf anymore at least, not at 3 pm (shocking) since life got a lot harder for bank(er)s. Nowadays banks face many problems and the traditional 3-6-3 model seems broken in several ways. At least in many developed markets this is the case. Many banks never felt the need for better efficiency, since they were hugely profitable before the great financial crisis (GFC). Afterwards, profitability was so low hardly allowing for investments and operations and systems are so complex now, that better efficiency does not come easily.
Many banks or more precisely their acquainted core banking systems are so old but essential, that dwindling experts/consultants can ask for exuberant fees.
Competitions is high, with some markets clearly being over-banked (read about The German Bank Paradox). Net interest margins or NIMs declined with overall interest levels and term transformation is not possible as in early days due to stricter regulation. Speaking about regulation brings me to …
That European banks face serious issues and some might even operate a broken busines model, becomes quite obvious when we take a look at their P/B ratios: HSBC 0.5; DB 0.3; Commerz 0.2; Santander 0.3; Unicredit 0.3; BNP 0.4; Barclays 0.3; UBS 0.7; CS 0.5. US banks trade on a higher P/B multiple.
Size matters! in banking but size is not good or bad per se in this sector. In theory, it should be possible to allocate overhead costs to a bigger base and thus size should be a positive for banks (as for most companies). But in practice, big corporations often feel internal frictions inhibiting the dreamed of efficiency and scale advantages. Banks should profit from bigger size (up to a certain level) when it comes to risk diversification. You need a minimum loan book for risk diversification and other statistical processes. A related question for banks is local vs global. Banks have to think hard about growing beyond a certain size since they have to adhere to the relevant regulatory enviroment (which is tougher for bigger banks). In relation to size, banks have to decide if they want to operate a global business (better opportunities, risk diversification) or a local business (expert knowledge of markets).
Valuing banks is a challenge. Usually I try to value companies performing a DCF valuation. But this makes little sense dealing with financial institutions. If you analyze banks, you basically have to trust their accounting and that their numbers more or less reflect economic reality and a reasonable estimate about the (likely) future. If we make use of some additional qualitative analysis, we should come to a good estimate of fair value. For a better understanding pls read Front Book, Back Book which explains a lot about banks.
I hope you enjoyed this post.
The next part will be about the first bank out of a few banks I will take a more detailed look on …