Alexandria, VA (May 18, 1998) -- Just so regular Drip readers know, I'm taking a week off starting Wednesday. It's off to Boulder, Colorado, for this Drip, where I'll be golfing, possibly camping, and maybe even skiing, although I've heard the snow really isn't where it should be for that activity.
Today I wanted to talk about leverage again, but this time I would like to propose an alternative to straight leverage, which is normally defined as average assets divided by average shareholders' equity. I keep track of a number of data points on the banking industry to know what average leverage is and where a company's leverage is in relation to that average. When I look at an individual company, I look at the composition of its assets, reserves, and risk-adjusted capital measures to assess the financial strength of that particular company. The composition of deposits is one of the things on the right side of the balance sheet that I look at, since not all liabilities are created equal. After all, some liabilities are more expensive than others. If we operated a bank that didn't have to pay any interest on deposits at all, we would have a huge competitive advantage over competitors that have to pay 5% on all their deposits.
Until this point, I haven't adopted a formal mechanism for scoring banks according to their noninterest-bearing deposits as a percentage of total deposits, except mentally when looking at a company's net interest margin. It does make a difference in the effective leverage ratio of the company, though. As a source of capital, checking account deposits are better than debt and better than equity. If it were debt, the company would have to pay interest on the debt. And if it were new equity, the company would have to issue shares to raise that capital. Because it's a checking account deposit, the company needs only to find the right customers and offer services that bring those checking account customers, and their low-cost to no-cost source of capital, into the fold.
Off the top of my head, I know that Wells Fargo (NYSE: WFC) has a particularly high proportion of noninterest deposits, as do the megaregionals like NationsBank (NYSE: NB) U.S. Bancorp (NYSE: USB). In general, companies that focus on attracting middle-market commercial accounts, or companies with less than $50 million in annual revenues, generate lots of noninterest checking deposits. Let's go to the database and rank the banks, according to their noninterest-bearing deposits to total deposits ratio, in descending order:
47.9%ï¿½..City National Corp.
25.7ï¿½..American Express (this is a synthetic ratio)
25.6ï¿½..First Tennessee National
25.5ï¿½..Mellon Bank Corp.
We want to convert this into a usable risk-scoring measure for the above banks, so we would look at the company's use of those assets, its margin, and its leverage adjusted for this hybrid source of capital. Since the cost of this capital is not directly observable on the income statement, and since the company has perpetual use of this capital, it has the characteristics of equity rather than debt. Deposits are usually thought to be more analogous to debt capital. Since it's tantamount to equity but does not require the further issuance of common stock to generate this capital, we can think of it as equity in our leverage ratios, too.
Moving it out of liabilities and into equity increases the equity base and, by definition, decreases the leverage ratio of the company. We can't move the entire noninterest deposit base into equity, though, because the bank has to set aside a higher amount of reserves to cover its demand, or transaction deposits. We also cannot penalize that heavily a bank that is too conservative with its transaction deposits, because we also like conservatism. We do want to see the company use its sources of capital intelligently, though. If it has use of the cash at no cost, then it should show up in the company's results, or else we really don't want to invest in the company.
We'll score the above banks in the database tomorrow.