Ten Commandments for Investing in Financials (Banks / Shadow Banks)
***Note: Reference to banks in the below essay includes both banks and non-banks/shadow banks
1. Avoid significant asset-liability mismatches
Banks make money by borrowing on the short end of the curve and lending at the longer end. In a normal scenario (when the yield curve is not inverted), short-term rates are lower than long-term rates and banks make the spread. However, when looking to invest in a bank, it is preferable for deposits to make up a huge chunk of the short-term funding, as deposits are often more ‘sticky’ (unless a bank-run has been triggered).
When banks do not have a great deposit franchise or are not allowed to take deposits in the case of non-banks, they are tempted to borrow heavily from the short-term funding markets. The occurrence of this is more probable in good times, when demand for loans is strong and credit markets are frothy enough to fund the lenders.
However, once credit dries up and roll-over of short-term market borrowings becomes challenging, the lender faces liquidity challenges. The bank may fail and its shareholders as well as its lenders / depositors will realize losses.
A well known example would be the British lender, Northern Rock which significantly borrowed from the short-term funding markets given its small deposit base and eventually was unable to refinance once capital markets turned sour. Northern Rock was eventually bailed out by the Bank of England in 2007. Similarly, several Indian non-bank lenders such as Dewan Housing Finance, Reliance Capital and Indiabulls Housing Finance faced similar issues during the credit markets freeze triggered by IL&FS defaults in 2017–18.
2. Be wary of concentrated asset books
Banks whose loan books are concentrated in particular sectors (think U.S. lenders highly exposed to real estate in the U.S. in 2005–07 or oil & gas in 2011–13) or geographies (think lenders in emerging markets) are inherently riskier. This is especially true when the sector or geography has gone through a boom period — loan books of such lenders grow fast, loss rates are low and ROEs are attractive. Investors clamor to get piece of the action — equity investors pay multiples of book value and debt investors buy are eager to subscribe to the bonds at rock-bottom yields.
However, if & when the boom time comes to a screeching halt, the most aggressive lenders fail or need government bailout. As investors, concentration of loan book should raise alarm even if the reported financials look great. The underwriting requires a more top-down assessment of the sector or geography the lender is exposed to rather than a typical bottom-up underwriting.
The largest bank failure in U.S. history thus far is that of Washington Mutual (“WaMu”) which had c. $307bn assets when it entered receivership in 2008. One of the key reasons driving WaMu’s failure was its large presence in the housing markets of California and Florida, two of the states hardest hit by U.S. housing crisis.
3. History is the best guide to assessing underwriting and risk management culture
Doing diligence on banks’ assets is incredibly hard for investors, especially those who do not have access to non-public information. Even for private equity investors, my experience tells me that it is a non-trivial exercise as the loan books could be compromised of ‘000s to ‘000,000 of loans and it is impossible to value the collateral underlying each loan and determine the recoveries in a stress scenario. Given the amount of leverage that banks’ balance sheets have, even minor reduction in asset values could have substantial impact on the bank’s equity value. The disclosed information such as loan stratification, NPL ratios, gross/net charge-offs and credit losses only tells you the state of the bank at a point-in-time and not in a stress scenario.
In the aftermath of the GFC, Fed constituted the stress tests for banks which have since been adopted by other global regulators, and give investors an important glimpse into the health of the banks. However, the stress tests are only available for the largest financial institutions, not transparent enough and subject to biases.
My strong belief is that loan underwriting and risk management are deeply embedded in the culture of banks and do not change overnight. Some banks are biased towards growth (which often drives stock price appreciation & management’s paycheck) while others are biased towards protecting downside in adverse scenarios. Needless to say, the former almost always go out of business. I’ve always found it helpful to go into decades of historical financial data to ascertain the performance of the loan books in periods of stress to assess the culture of the bank. This approach precludes me from investing into up-and-coming lenders that have not seen cycles, but is a price worth paying for investing well in the sector.
4. Be skeptical of the off-balance sheet loan books
Securitization or off-balance sheet lending is a neat idea which allows capital recycling by the originator bank and deepens the pool of capital to fund productive growth in an economy.
However, just like any good idea taken to the extreme, excess securitization is bad. The main cause is that it becomes a upfront fee (non-interest income) game for the bank and the quality of underwriting likely deteriorates. It doesn’t help that often the lowest tranche of the issuance is required by regulations to be held on balance sheet by the bank and any asset quality deterioration hits the bank first.
Banks engaging in the above are particularly more risk prone during times of frothy capital markets when investors can’t seem to care about underlying loans and can absorb just about any issuance.
The GFC was caused and exacerbated in large parts due to securitization of sub-prime mortgage backed securities which were widely distributed and considered riskless due to groupthink and flawed models of the credit rating agencies.
5. Even banks should stick to their “circle of competence”
Warren Buffett says that while making investments, he sticks to his “circle of competence”. Banks similarly should stick to their circle of competence — a bank’s loan book and investments should be in products and geographies it knows best.
Lenders in developed economies, especially in countries with high savings rate and low domestic investment, tend to go to emerging markets in search of growth and yield. While the rationale of such moves is understandable, more often that not, the banks are not local enough to assess and price the underlying risk. Understandably, losses ensue and the banks scale back their operations to focus on the areas they know well.
Similar fact pattern is seen with regards to products, where banks expanding into products where they have little experience, quickly realize that grass was not that green. Examples of this are easy to find. Japanese banks have realized substantial losses due to investments in foreign debt. Similarly, UBS blew through some $40bn by investing in US sub-prime mortgage securities having relied on credit ratings agencies who rated the securities AAA (UBS outsourced its underwriting function!)
6. Don’t let Ponzi economics fool you
Some times the financial sector of an economy seems to be in a Goldilocks scenario. Loan books are growing rapidly, ROEs are high and LTVs on the underlying loans seems fairly conservative. Bidding up to 3x or 4x P/B for lenders does not seem that irrational.
While the above may certainly be a Goldilocks scenario (for example, Kotak Mahindra Bank in India?), we need to be worried about times when it is not. “Ponzi economics” is when an economy is in a credit fueled bubble without corresponding gains in productivity:
- Low interest rates in a relatively robust economy results in high demand for credit
- Banks respond to the demand for credit and their loan books grow swiftly and the bank profitability is high
- The supply of credit results in increasing asset prices such as that of real estate
- LTVs for loans falls and borrowers refinance while higher loan amounts are made based on a an elevated asset value
- Things are looking rosy for the banks until excess inflation shows up
- Central banks begins increasing interest rates, demand for credit reduces, asset prices fall and eventually, the loans go under potentially wiping away the banks’ equity value
Spain’s banking system was victim of the above as interest rates remained artificially low for long due to the common monetary union fueling an asset bubble which came crashing in 2008.
7. The “Game of Bank Bargains” — Role of Regulators & Politics
One of the theories that I found very insightful is proposed in the book, “Fragile by Design” and is called the “Game of Bank Bargains”. As per the theory governments are conflicted in regulating banks:
- They simultaneously borrow from banks and regulate them
- They enforce debt contracts but need the political support of the debtors
- They distribute losses in the event of bank failure but need the political support of depositors
An implicit partnership emerges between government and certain private actors in the economy — “Game of Bank Bargains”. The structure and outcomes of the banking system are heavily influenced by who holds relative power vis-a-vis the government.
Lets explore the example of China (my interpretation, the book does not explore China as a case study):
- China uses its banking system as a policy tool for its goal of maximizing employment
- Given the government’s historical approach of an investment-driven economy, SOEs and large private enterprises became the major drivers of employment in China and hence politically crucial institutions
- SOEs and large private enterprises needed credit to be freely available at low cost in order to undertake investments and compete globally in asset heavy sectors
- As a result of this implicit co-dependence between the government and enterprises, the banking system in China gave away abundant credit with low underwriting standards at artificially low cost of capital to SOEs and large private enterprises
- The victims of such a banking system are the household savers who get lower return on their savings and fund banks bailouts as well as the investors in these banks
- China can sustain this system because of its autocratic political system
Chinese banks have already had two large NPL cycles in the past 20 years, one in the late 90s and one underway currently. Meanwhile, ICBC’s P/B multiple has fallen over 80% from ~4.0x in 2007 to ~0.7x currently. As such, while investing in a bank, it pays to understand the political underpinnings of the banking system of the country.
8. Be more pessimistic in your downside case — Black Swans are not that uncommon!
Pretty self explanatory, but banks and investors in the banks tend to be bullish about the underlying collateral and investment values especially when things are going great.
However, as Daniel Kahneman highlights in his book, “Thinking Fast and Slow”, it has been proven that humans have certain biases including confirmation bias, overconfidence and over-optimism which lead us to behave in pro-cyclical manner.
It always helps to take a detour into history and if asset values and credit metrics are a few standard deviations above the mean, then its reasonably to assume that gravity will put it down sooner or later (instead of the typical bull market response of “this time its different”). As an example, after house prices had risen 85% in the decade ending 2008 in the U.S., Freddie Mac’s expected a maximum decline of just 13.4%, a grave mistake in hindsight.
9. Creative destruction is slower in the lending business
FinTech is all the rage in the VC community and the consensus view is that FinTech is eating the lunch of banks. Peeling below the surface, one can see that FinTech companies are taking market share away from banks in non-core areas such as merchant acquisition or serving underserved communities & businesses as in the case with Chime. However, the core business of banks of lending to prime borrowers has remained unassailed and continues to grow. Creative destruction has not been as pervasive and perhaps that’s why Warren Buffett remains a prolific investor in banks.
The driver of the strength of traditional banks’ lending franchise is the low cost of funding in the form of large deposit base. The deposits in turn are driven by the brand & trust that banks have earned over centuries along with a healthy dose support from the regulators (as seen during GFC though it did give rise to a non-trivial Bitcoin movement). As an example, Wells Fargo was founded in 1852, JP Morgan in 1871 and Bank of America in 1904. Having said that, banks’ moat from a scaled branch network are lower as internet banking penetrates consumers.
What that means for investors is that banks with strong established franchises can continue to compound for a very long periods of time. The only caveat is that investors need to buy banks at reasonable prices to be able to see returns — overpaying can result in mediocre or poor outcomes.
10. Management quality is paramount for leveraged institutions such as banks
I touched upon the important of culture of conservative underwriting and risk management in point #3 above. The management acts as the steward of such culture and hence is an important consideration when choosing to invest in a bank. Management integrity is also critical as banks deal with the lifelong savings of individuals. Warren Buffett’s Berkshire Hathaway shareholder letter from 1990 perhaps best encapsulates this point:
The banking business is no favorite of ours. 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. And mistakes have been the rule rather than the exception at many major banks…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.
