Alexandria, VA (May 19, 1998) -- Yesterday, we introduced the concept of making some adjustments to the right side of a bank's balance sheet to get a better look at capital efficiency. (The left side of the balance sheet shows the assets, or resources at a company's disposal, while the right side shows the liabilities and owners' equity, or the source of the assets on the left side of the balance sheet.) The basic premise here is that those companies that have a significant amount of noninterest-bearing checking deposits have a great advantage over those banks that don't have such a deposit base. For those with a small deposit base, their cost of deposits is going to be larger. In addition, checking accounts are great generators of fees that come from overdraft and maintenance charges.
Since a larger bank has the perpetual use of billions of dollars on average during the year at no cost or at a very low cost, like equity, we are going to move some of these funds down the balance sheet into the equity section. Not all of the funds can be moved down, though, since large banks have to set aside approximately 10% of their noninterest-bearing deposits as noninterest-bearing cash reserves. We also don't want to take the approach that anything above and beyond that 10% reserve is free and clear. So, we will allow reserves of 60% of noninterest-bearing deposits to remain in liabilities while we move 40% of average noninterest-bearing reserves down into the equity section of the balance sheet.
The reason we are doing this is because I am continually learning new ways to assess a bank's performance. While I believe that return on assets (ROA) and return on equity (ROE) -- and the various adjustments thereto for goodwill amortization -- are highly useful tools, I think they are basic and they don't totally satisfy me. There is a lot of capital between total assets and owners' equity. Eventually, I want to get a uniform view across the sector of net invested capital a bank has at its disposal, and that lies somewhere between assets and equity. This adjustment doesn't satisfy all of that need, but it does at least provide an improved view of how well a company uses all its sources of capital.
While I haven't updated my entire database for this new measure, here are some of the results that I have seen so far:
Citicorp (NYSE: CCI)
Citicorp's noninterest-bearing deposits-to-total deposits ratio is low to begin with. Compared with an average 22% for the 14 money center commercial banks and superregionals that I follow, Citicorp's 12.27% ratio is tiny. A low amount of noninterest-bearing deposits is actually a hallmark of a money center bank, since such companies go into the market and buy deposits via the issuance of jumbo certificates of deposit (CDs) and commercial paper. Given the huge size of Citicorp, though, more than $10 billion in average noninterest-bearing deposits are moved down into equity, which brings the company's amortization-adjusted ROE (which is earnings before goodwill amortization divided into average tangible shareholders' equity) down from 19.7% to 13.31%. The company makes good use of its noninterest-bearing deposits, but remember, this isn't a huge leap for Citicorp, since it operates with relatively small amounts of this type of funding to begin with.
NationsBank (NYSE: NB)
Bear in mind that with NationsBank, I still have to make estimates for the company's trailing twelve months of earnings because of its Barnett Banks acquisition. That deal didn't close until after the fourth quarter ended, so I still haven't seen pro-forma numbers from the bank on the past four quarters. NationsBank generates a huge float of noninterest-bearing deposits, nearly twice as large as Citicorp, in fact. This is because NationsBank is bigger in middle-market and small business lending, where companies have fewer financing and banking alternatives than large companies. NationsBank is also ubiquitous in a number of markets, and thus captures a good deal of consumer checking deposits. Its amortization-adjusted ROE is around 30% while the more than doubling of its equity capital base from this adjustment doesn't knock that down to a sub-par level. Its 14.6% ROE is excellent.
American Express (NYSE: AXP)
American Express makes use of its noninterest-bearing deposits by design. Its noninterest-bearing deposits are generated through the issuance of its famous Travelers Cheques. Between the time that it issues the Travelers' Cheques and the consumer uses them, the company gets the use of those funds plus a fee. I actually got the idea of making these adjustments to the banks because of Amex, since it uses this float very well. The float is normally carried as a liability, but there is very little equity needed to support this liability. Therefore, in Amex's case, I have moved 70% of its more than $5 billion in average noninterest-bearing deposits down into equity. Its amortization-adjusted ROE moved down from 22% to 15.3%. An excellent performance that will probably stand as the highest in the group, because Amex uses these funds by design to invest in higher-return portions of its business rather than letting the cash sit in short-term investments.
I will include this measure in future reports on companies because it's useful to see how a company makes use of all the funds at its disposal. I will continue to tweak capital measures to arrive at standard performance measures across the sector. I don't feel comfortable just looking at return on equity, because banks have a lot more funds at their disposal than just owners' equity. More updates as we go along.
I'm off for a week! See you when I get back.