The big 3 banks DBS, OCBC and UOB have plunged significantly ever since trade talks between the US and China have stalled. This has somewhat caught my attention as some of them are moving towards their 52-week low. I have always been wanting to add some banking stocks to my portfolio, but I realised that analysts reports from various brokerage firms on banks are always discussed in a slightly different tone. It is filled with confusing jargons and abbreviations such as NIM, CASA, CAR, CET, ECL and CIR. If you are as confused as me, you are in the right place. This article is written to demystify all these complex jargons and understand the banking system from the inside out. By the end of this read, you would be more familiar with how to analysing banking stocks.
Introduction to the Banking System
Banks, unlike any other traditional businesses, have a more complex financial statement as their profits are generated in a different way. They don’t buy inventories to stock-up for sale nor do they purchase machinery for mass productions. There are no accounts payable to suppliers or accounts receivables from customers. Profits are made simply with money. In the world of banks, it takes money to make money.
This is done through a concept known as fractional reserve banking. Banks have the legal right to lend out all the money that is being deposited with them. The condition is just to maintain a certain % of minimum cash reserves. If you deposited $10,000 of money with Bank A and the minimum threshold is 10%, the bank would keep $1,000 and loan out $9,000 to a business with an expected interest to be paid back. This $9,000 would eventually be spent and deposited in another Bank, say Bank B. Bank B then keeps $900 and loans out $8,100 to another person and the money is again being deposited in another Bank, maybe Bank C.
This cycle repeats itself until almost all the money in circulation today is credit money. The money that is going on around is solely based on pure faith that you and I will return the principal + interest back to the banks dutifully. It can be seen that the initial deposit amount of $10,000 has multiplied magically to $27,100 ($10,000 + $9,000 + $8,100). That is how money is being created and the balance sheet of each bank would look something like this.
On the right-hand side of the T-account is the liability and the left-hand side represents the assets. When you deposit money into any of the banks, it is a liability to the bank as they have to return you the amount of deposits as and when you wish to make a withdrawal. However, you might notice that the bank only has 10% of your money. The other 90% are all being lent out. If that’s the case then where do they get the money to return you?
The reason why this model works is simply because not everyone is withdrawing the full deposit amount at any one point in time. If every single depositor demands their money back all at once, it would lead to a scenario known as a bank run. It is the situation when banks have insufficient money to provide for the total amount of withdrawal from depositors. The only time this happens is usually during a depression or when people simply lost faith in banks.
In reality, there are hundreds and thousands of depositors depositing money and withdrawing money from banks every day. Some banks will have more inflows (depositor’s money) than outflows while others will have more outflows (withdrawals) than inflows. Hence, banks lend each other money using the overnight lending rate or SIBOR so as to meet the minimum cash reserve ratio requirements.
Reserve Requirements, MCB
The official regulatory term for the minimum cash reserve ratio is known as the Minimum Cash Balance (MCB). All banks in Singapore are required to maintain an MCB equivalent to at least 3% of their total liabilities base. This liability base refers to the total amount of money that is being deposited with the bank.
This is not to be confused with the capital requirements or Capital Adequacy Ratio (CAR) which we will be discussing in the next section. MCB is a regulatory requirement that states the minimum amount of reserves a bank should hold for every dollar of deposit. If person A deposits $100 in Bank A, the bank has to keep $3 in their vaults if an MCB of 3% is used. $97 can be loaned out freely.
On the other hand, CAR is to ensure that the bank has sufficient liquid capital to support the loans. Having some form of minimum capital requirements provide a cushion buffer to withstand any unexpected losses and also to prevent the banks from taking excessive risks.
Capital Management & Planning, CAR
The CAR measures a bank’s capital in relation to its risk-weighted assets. It is based on the Basel lll accord, which is an international regulatory committee designed to regulate and supervise risk management within the banking sector.
To start off, a bank’s capital consists of Tier-1 capital and Tier-2 capital. You would see these terms used commonly in the banks’ annual report or analyst report.
Tier-1 capital is the bank’s core capital and it is the highest rated capital. It is mainly made up of the shareholder’s equity and retained earnings. Tier-1 capital is further sub-divided into Common Equity Tier-1 (CET-1) and Additional Tier-1 capital. Additional Tier-1 capital is simply Contingent Convertibles or (CoCos) that have the potential to be converted into equity. This tier-1 capital is like a back-up cash reserve to absorb losses or mass withdrawals without being disrupted from its regular business operations. It is the bank’s core savings and they are highly liquid and readily available to be converted into cash immediately.
Tier-2 capital is supplementary capital which is secondary to the bank’s core capital. It is made up of items like revaluation reserves, subordinated debts, hybrid instruments and undisclosed reserves. Tier-2 is less reliable than Tier-1 as they are harder to be measured accurately and the assets are not as liquid as Tier-1 capital.
Adding Tier-1 capital and Tier-2 capital gives us the Total capital of a bank. The reason why there is a need to understand Tier-1 and Tier-2 capital is because there is a CAR ratio for each category.
The capital adequacy ratio under the international guidelines and MAS regulatory requirements are as follows. MAS has higher capital requirements than the international standard of Basel lll. Here is the official link to MAS’s CAR requirement if you are interested to read up more. The percentages shown are a % of the risk-adjusted assets.
During the 08′ economic crisis, Basel lll also introduced two additional buffers known as the:
- Mandatory “Capital Conservation Buffer” of 2.5%
- Discretionary “Counter-Cyclical Buffer” of 0% – 2.5%
Hence, the column we should be looking at should be the far-right column. All the banks in Singapore have to meet the capital requirements or CAR of CET-1, Tier-1 and Total.
To piece everything up together, let’s see what is DBS’s Tier-1, Tier-2 capital and its CAR ratio.
DBS’s CET-1 capital is $40.24 billlion, Additional Tier-1 Capital is $3.39 billion, Tier-1 capital (CET-1 + Additional Tier-1) is $43.63 billion and total capital is $48.8 billion.
The total risk-weighted asset is calculated to be $289.63 billion. To calculate CAR %, simply take the CET-1 capital, Tier-1 capital and total capital divided by its risk-weighted assets. Here is a summary of how their CAR % is being calculated.
You can see from above that DBS has comfortably exceeded the minimum required ratio set out by MAS. DBS’s target ratio for CET-1 is 13% +- 0.5%.
How Do Central Banks Influence Money Supply?
The amount of money circulating in the economy is paramount to banking stocks. The more money there is going around, the more people take up credit loans, and the more profits banks make. The booming economy we are enjoying right now is largely driven by credit expansion. Someone’s spending is equivalent to someone’s income. The more people spend, the more people earn, the more money is being deposited, credit rating goes up, asset prices go up, risk level goes down, more money is being lent out and the cycle keeps repeating itself. When the central bank and government feels that the economy is overheating, they will reduce the amount of money supply through either of these 3 monetary policies.
The first one, which most of us would be familiar with, would be fed’s interest rate hikes. When people are borrowing too much money, they increase interest rates so as to reduce cheap money and borrowing activities. When the interest rate goes up, it will have 2 effects on banks.
Firstly, borrowing and lending activities would decrease as the interest rate goes up. This means that the bank earns lesser from interest income as there are lesser loans going around. Secondly, the net interest rate spread of banks would be compressed. This is because the bank has to pay higher interest to depositors.
However, it may not always be the case. Increase in interest rates could also lead to more people shifting their money from equities or bonds into their safe-haven bank accounts. When this happens, the cash reserve increases and banks can lend out more money, thus earning higher interest income. Increase in interest rates also increases their interest income directly as existing and future loans become more expensive. As long as more loans can be borrowed out to cover for the increase in interest expenses paid to depositors, the bank can still profit. The challenge is getting people to borrow when interest rates are high.
The second method would be to change the reserve requirement ratio or the MCB. If the economy is overheating, MCB would increase and banks have to keep a higher portion of capital with the central bank, thus reducing the total amount of loans. When less money can be loan out, the money supply in the economy decreases. Banks have lesser money to loan out, and interest income falls.
The third method is by conducting open market operations. This is where the federal reserve buys government bonds from banks, thus injecting money into the economy. If there is too much money, the fed sells these bonds to remove money from the economy. This is somewhat controversial as the fed writes its own cheque without having any money in its vault. It is as if writing a $100 sign on a piece of blank paper and using it when playing monopoly.
These are macro factors that one should keep in mind when analysing banking stocks as we are talking about money supply and the global economy. Banks are all about money supply. When the money supply increases, bank profits. When the money supply decreases, bank contracts. It is important to note which stage of the economic cycle we are in and whether the economy is expanding or contracting.
Bank’s Financial Statement
Alright, that is just some context about the banking system and how they operate as a whole. The good thing is that banks, regardless of which countries they are from, works pretty much the same way. Understanding a brief background of how the banking system operates allows you to analyse any bank companies in the world.
Let’s move over to the financial statements and see how they look like. I used DBS’s latest annual report 2018 as a reference to go through the process of understanding a bank’s financial statement.
Net Interest Income, CASA, NIM Margin %
To start off, a bank’s consolidated statement usually begins with interest income less interest expense to give net interest income. Interest income is the interests the bank earns from loaning out to SMEs, businesses, car loans, tuition fee loans, personal loans, housing loans etc. This can be anywhere from 2% to 10% depending on an individual’s risk factor. Interest expense is the interest that the bank pays you, which is probably that meagre 0.05% to 0.15%, depending on how much you have in your bank. Or 1.5% to 2% for Fixed Deposits.
There are 2 important things that I would look out for when analysing net interest income. The first is the Net Interest Margin (NIM) %. This is the spread difference between the cost of lending and the rate of lending. It is calculated by taking net interest income divided by the average earnings assets. You can think of net interest income as the gross profit and NIM as the gross profit margin. It is the core earning strength of a bank. It is earnings from a bank’s principal activity which is lending. You would often see business news and analysts report talking about NIM expansions, which simply means loans are growing.
The second thing that I would look out for is Current Accounts & Savings Account (CASA) & Fixed Deposits (FDs). Both of these adds up to give the total amount of deposits being made to DBS. The total deposits and balance should increase steadily and consistently. This is because the more money a bank has, the more money it can loan out.
However, it is also important to take note of the differentiation between CASA and FDs. CASA is a cheaper source of funding as compared to FDs. CASA has a lower interest rate % of around 0.25% to 0.5% while fixed deposits are usually higher at around 1.5% to 2%. Ideally, you don’t want people switching over to Fixed Deposits as that translates to an increased cost of funding. This is because FDs pay a higher interest rate than CASA.
Using the example above, we can see that even though deposits and balances from customers have increased from $373 billion to $393 billion, the proportion of Fixed Deposits has also increased from 36% (137,696/373,634) to 40% (159,049/393,785). This means that DBS’s cost of funding will be higher than if FDs retains its same proportion at 36%.
Moving down the line, we have to add on all other Non-Interest Income before arriving at the total income. Non-interest income is things like brokerage fees, service fees, transactions fees from investment banking, wealth management, card fees, late payments, trading income, investments etc. These are income that is not derived from the lending activities, hence the term non-interest income. Adding the interest income and non-interest income would give the total income of the bank, which is about $13.18 billion for DBS.
Efficiency of Operating Expenses, CIR
After calculating total income, we have to also deduct salary expenses, executive compensation, bonuses which all fall under employee benefits. There are also other expenses such as the depreciation of computer hardware and software, rental for buildings, offices as well as other administrative expenses such as audit fees and maintenance fees. Adding all these expense items up would give the total expenses and it can be viewed as the operating costs of a business.
One way to evaluate the efficiency of managing operating costs is by looking at the Cost-to-Income ratio or (CIR). This is calculated by taking total expenses divided by total income. The total expense for DBS for FY 18 is $5.81 billion and total income is $13.18 billion. Take $5.81 billion / $13.18 billion would give us 44%. That is how the CIR ratio % for FY 2018 is calculated.
You can use the CIR ratio to compare across other banks to see which bank is the most efficient in keeping operating expenses low. If a CIR ratio is high, it is not necessarily a bad thing. We have to understand why and what it is spending on.
For example in the case of DBS, most of its IT needs are being outsourced in 2009 to external parties. However, they have since made the strategic move by deciding that they will house their own IT infrastructure. As of 2017, 85% of its technology is now insourced from DBS’s internal IT department. This calls for heightened IT spending on technology, software, infrastructure, hiring of IT specialists and operating expenses will inevitably go up. DBS is planning to undergo a massive digitalisation transformation as these are the emerging trends in the next 3-5 years. There will be R&D expenses, investments in technology and hence a high CIR might not necessary means its bad. It depends on whether their operating expenses translate to increased productivity in the long-run.
Specific Allowances using ECL Model
After deducting all the operating and administrative expenses, there is still a need to record allowances for credit and other losses. This is equivalent to delinquent account receivables where customers are unable to pay up due to bankruptcy or liquidity issues. Similarly, in banks, not 100% of the money being loan out are expected to be repaid. There will be some businesses or individuals that will default on their loans due to perhaps a failure in the business venture.
Under note 12 of DBS’s annual report, you can actually see the specific allowances classified based on their individual sectors. The highest amount of loans that are not expected to be recovered comes from professional and private individuals followed by the manufacturing industry and general commerce. The total specific allowance adds up to $657 million and this means that $657 million of loans are not expected to be recovered. Do take note that this is just an estimate.
The calculation of allowance for credit loss is based on the Expected Credit Loss (ECL) model. This is more on the accounting technical side of things. The ECL is a product of the Probability of Default (PD) x Loss Given Default (LGD) x Exposure at Default (EAD) discounted using the original effective interest rate to the reporting date. EAD is the amount of loss a bank is exposed to when the loan defaults. LGD is the net loss the bank suffers when a loan defaults. This is because some loans have collaterals. If a loan of $3 million is backed by a property that is worth $1.2 million, the net loss to the bank is $1.8 million and not $3 million. PD is just the probability the loan would default.
The key thing to take note is to observe for the general economic direction of businesses. If their credit risk increases due to a weakening economy or uncertainty from the US-China trade war, then it is likely that the net profits will take a hit as the write-offs expenses would likely increase using the ECL model.
Evaluating Asset Quality & Allowances, NPAs & NPL Ratio %
Specific allowances for credit losses tie in closely with the quality of assets. There are 2 important metrics to look at and that is Non-Performing Assets (NPAs) and Non-Performing Loan (NPL) Ratio. NPAs are simply loans that are close to default. A loan is considered to be an NPA if payments are overdue for more than 90 days. There are 3 classifications of NPA which are sub-standard, doubtful and loss. You can read about the classification grade of NPAs here.
NPAs for DBS have decreased from $6 billion to $5.6 billion due to higher net repayments and write-offs. What you don’t want to see is NPAs increasing over the quarters as that means the quality of loans is deteriorating. NPAs tell us about the quality of assets as well as give us an indication of an impending economic crisis. If more and more loans are turning to NPAs, it is definitely not a good sign as that may be reflective of a slowing economy.
The second metric is the NPL ratio. NPLs and NPAs pretty much mean the same thing. The only difference is that NPLs EXCLUDE debt securities and contingent liability.
The formula for calculating NPL ratio is simply to take Total Non-Performing Loans divided by Total Gross Loans. DBS’s non-performing loan is 5,251 divided by its total gross loan which is 349,645 would give us an NPL ratio of 1.5%. Again, the general guideline for NPL is payments of interests and principal that are past due by 90 days or more. Since this is a relative ratio, you can compare the NPL ratio across all 3 banks to get a feel of which bank has the highest quality of loans.
Finally, the bottom net profit of $5.65 billion is arrived after deducting allowances for credit losses and paying income tax expenses.
To recap, total income is made up of both net interest income and non-interest income. Net interest income is a bank’s core earning and it is calculated by taking interest income less interest expense. Non-interest income is all other incomes except interest earnings. The total income is being deducted by employee expenses and other operating expenses. And lastly, we have to make an estimate of credit losses based on the ECL model and pay taxes to the government before arriving at the net profit figure.
The profitability of a bank can be measured by looking at whether NIM is expanding. The cost efficiency of a bank can be measured by looking at CIR %. The quality of loans and assets can be measured by looking at NPAs & NPL ratio %. The cost of funding can be analysed by looking at CASA & Fixed Deposits.
We have also covered how the banking system works, how to calculate CAR and what the CAR ratio is under Basel lll & MAS requirements. A bank’s capital is made up of Tier-1 capital and Tier-2 Capital. We need to compute the Risk-Weighted Assets and ensure that the different tiers capital meet the minimum CAR requirements as set out by MAS.
Lastly, we have also gone through on how central banks influence the money supply and why it is important to evaluate at which juncture of the economic credit expansion we are in right now. This is because the vibrancy of banks depends very much on the supply of money circulating in our economy. This is just a brief overview of the banking sector and it is with the hope that you would be more familiar with all the abbreviations and jargons when analysing banks.
Stay tuned for part 2 of analysing banking stocks.