ALEXANDRIA, VA (March 17, 1998) -- Here's a brief look at the key areas we will be studying over the next couple of months. We won't be bound by a syllabus, but this outline will serve as a guide or a table of contents for you. As we go along, I expect this outline to evolve to meet the needs of DRIP Portfolio participants and also to incorporate anything that might have slipped through the sieve that is my mind.
I present below an annotated outline for where we plan on going.
1. What Is a Bank
We will look at banks as retail and wholesale institutions. Banks are no longer a 3-5-3 (borrow at 3% from depositors, lend at 5% to borrowers, and get to the first tee by 3 o'clock) sort of business. The entire industry is consolidating, as the U.S. is an over-banked country. Congress and state legislatures have traditionally favored this fragmented environment due to the historical American distrust of concentrated money interests. From the days of liquidity crises arising from post-Revolutionary War banks issuing watered-down bank notes, to the Jackson administration shutting down the Second Bank of the United States in a democratic fervor, to reform-minded legislators calling J. Pierpont Morgan to the carpet in Washington, to the more recent history of the Keating Five scandal, Americans have feared concentrated financial power. Our culture is imbued with anti-bank themes, which were embodied in John Steinbeck's The Grapes of Wrath and L. Frank Baum's The Wizard of Oz, which was itself an illustration of the argument between a gold standard and the inflationary free coinage of silver.
Believe me, we won't dwell on a touchy-feely discourse of Populist thinking on banks when we get to this section. We'll deal with the thesis that banks have potential to be, and are, very powerful consumer brands. You cannot escape the influence and presence of the financial services industries in your daily life. You might not drink a Coke every day and you might not eat Frito-Lay products every day, but your money is either sitting in a bank or flowing through a financial services firm in some way each and every day. We'll look at the retail presence of banks as well as the wholesale businesses that these companies have built and how different business lines will shape performance going forward.
2. Banking Financials: The Income Statement
The day you've all been waiting for. The financial statements of financial services companies aren't as complicated as you might think. You just need to alter your perspective on the organization of the financials and get comfortable with accrual concepts of accounting. As opposed to cash-based accounting systems, where expenses and revenue are recognized simultaneous with the flow of cash in and out of the business, accrual accounting recognizes that there are timing differences between the receipt or the payment of cash and the recognition of those flows of cash as revenues or expenses.
In this section, we will look at the peculiarities of a financial services company's income statement, including:
-- Provisions for loan losses, charge-offs, and credit quality. How do these accounting entries reflect credit quality and the quality of earnings?
-- Net interest income. When we use the terms "net interest income" or "non-interest income," we are talking about revenues. Do not confuse these terms with "earnings" or "net income," which you will see as the bottom line in other sorts of financial statements. Net interest income is a major component of a bank's or financial company's revenues. It's also interesting in that expenses are counted as a component of revenue to get to the "net" in net interest income.
-- Non-interest income. There are many components to this revenue figure, including gain-on-sale components. This will lead us into a discussion of where banks are going as financial services companies as they diversify away from being companies that take in deposits and lend those deposits out to earn a spread between the cost of those deposits and the interest on loans made with the money that is entrusted to the bank as deposits.
3. Banking Financials: The Balance Sheet
When looking at any company's balance sheet, you should get a sense of what is happening with the income statement and the cash flow statement. A bank's balance sheet (and, highly important, the notes to financial statements) has a lot to tell -- how conservative the company's financial policies are, the riskiness of the company's earning stream, what businesses the company is in, how the company funds its operations, a rough picture of its cost of capital, and what its acquisition strategies have been.
These things aren't going to just jump off the balance sheet at first look, so we'll go as slowly or as quickly as we want here. The issues I mention above tie into much of what we will discuss as we go along.
Someone once said that a company's capital structure doesn't have a bearing on its performance as a company. I am sure that may be correct, but only correct within a philosophical framework with which I am not familiar. The way a company funds its operations, whether through equity or debt, has a great deal of bearing on what sort of lines of business the company can enter, its requirements for return on capital, and how it can thus build shareholder value.
Traditionally, banking has been a capital-constrained business. Much of the business still is because the Federal Reserve requires them to maintain a certain assets-to-capital ratio to qualify for the lowest-cost federal deposit insurance. We will look at measuring capital and banks' requirements thereon, how to measure capital efficiency, how to measure the productivity of all assets, and how to look at the efficiency of equity capital employed by a financial services company.
I wrote about this a few weeks back when I did an article on American Express (NYSE: AXP). To calculate ROE, or return on (average) owners' equity, we use the following (A x B x C) model:
One year's earnings ROE = (A) --------------------- multiplied by One year's sales One year's sales (B) --------------------- multiplied by Average Assets Assets (C) --------------------- Average Shareholder's Equity
This equals the traditional measure of ROE, since "sales" and "assets" in the set of numerators knock out "sales" and "assets" in the set of denominators. Thus, the simpler formula:
One year's earnings ROE = ------------------------------- Average Shareholder's EquityThe quality of ROE is found by looking at each component in the top set of measures, which are otherwise known as profit margin, asset turnover, and leverage.
More on the outline tomorrow.