ALEXANDRIA, VA (Mar. 18, 1998) -- Having left off yesterday with a formula for looking at the quality of a company's return on equity (ROE), which is one of the components for assessing the performance of a financial services company, we pick up the outline for our study at capital efficiency.
5. Capital Efficiency and Risk Measures
Pure returns on capital aren't the only thing you want to look at in assessing capital efficiency. A high ROE is great, but you want to know what's generating that return. Is it leverage, margins, or asset turns? Yesterday, we looked at the basic outline of how to do that, but there's another element that should be added to the mix. We want to look at a company's risk-based return on capital.
Risk in the financial services industry comes in many forms:
-- Counter-party risk, or the risk that someone who took out a loan won't pay you back or someone who is contractually obligated to you won't perform an agreed-upon service.
-- Interest rate risk. This comes in many flavors, but we're interested in how various interest rate scenarios can affect a bank given the bank's term structure (we'll explain this when we get to this section) of interestrate-related assets and liabilities. Also, over last year, long-term interest rates have come down quite a bit while short-term rates have not. We will look at the implications for companies in our study, both from a risk-management perspective and from the perspective of asking how a bank can excel in such an environment.
-- Asset mix. If you lend all your money to highly leveraged Thai companies, and then the Thai baht falls out of bed and the economy is turned inside-out, you know what asset mix risks are all about. We will look extensively at the composition of asset risk and how this risk interacts with a company's capital structure. I suggest you read a document from the Bank for International Settlements, an international central bank established by theHague Agreements of 20th January 1930. This is an international clearinghouse bank that also serves as a clearinghouse for ideas to be shared among central bankers. The document is available at http://www.bis.org/publ/bcbs04a.htm and will help you understand the risk-based capital measures used in constructing risk-based performance data on banks.
-- Moral hazard. When we look at the S&L crisis, this will come up.
6. Bank Mergers and Acquisitions -- Prices Paid and Value Received
This is a source of wonder and merriment for many in the media. It's just so easy to say, "Holy cow! Four times book; this market is crazy!" Maybe so, but that doesn't get close to the heart of why banks pay what they do for other companies. We need to get inside these acquisitions and look at:
-- How companies build shareholder value.
-- Why paying a large multiple to book value isn't necessarily a bad thing, depending upon the acquired company's earnings growth rate, earnings retention rate, and excess capital on its books.
-- Purchase vs. pooling-of-interest accounting. When a bank purchases another company and the acquisition is done at a price that surpasses the appraised net asset value of the acquired company, an asset called "goodwill" is generated. We will look at what that asset represents and how, in many cases, amortization expenses associated with the asset can be totally ignored.
-- How to spot undervalued banks. If a bank is situated in a highly desirable geography and has a good customer base, but is not a top performer financially, do you value it off its current financials or its potential financials? Hint: It's the second choice. We'll look at why that's the case.
-- Cost savings and "synergies." Where do they come from? And is the idea of economies of scale for real? We'll look at how to model cost savings and what sort of cost savings and synergies can be expected from different types of mergers and acquisition.
7. An S&L Redux
We can't spend all this time talking about banks, thrifts, and financial services without using what we've learned to better understand what the heck the S&L crisis was all about. Was it a case of evil operators or misguided regulators? Also, we'll touch on the famous goodwill case that is still pending.
8. The Future of Banking
Banking will never go away -- the storage, exchange, and growth in capital is a hallmark of our humanity. The utopian ideal of digital money superseding any tangible form of exchange medium will probably never come to pass. Even if there is no tangible currency, there needs to be media of exchange, which include digital money and the institutions needed to perform as intermediaries trusted by both parties in a commercial exchange. It is for this reason that there are inherently attractive features of the banking and financial services industry -- namely, that it will always be around, similar to purveyors of food. As long as these companies are around, there will be some that excel in offering quality services at a low cost with a minimum of superfluous capital involved in doing so. That being the case, the financial services industry will continue to offer plenty of opportunity for investors.
Premium banks of the future will be able to handle intermediary functions such as bringing together borrowers and lenders and providing securities and merchant transaction processing, both on retail and wholesale levels. They will also continue to grow as producers of financial services such as mutual fund management and business services. Insurance underwriting, for instance, is one area the banking industry wants to enter. Just as bankers got the deregulation they craved in the 1980s, the industry will probably be able to enter into this activity in the coming century. However, deregulation was too much for some overexcited bankers to handle in the 1980s and this next bit of evolution will probably be no different.
The more value a financial services company can add to services and the better it can integrate an array of services, the closer it can get to its customers. When we look at the future of banking, this will be a major theme of the analysis and will be something we look at when we get into analyzing individual companies.
Tomorrow, we start with the question, "What is a bank?"