If you strip away all the noise, banks are nothing more than highly leveraged funds. They lever up a sliver of capital by borrowing money from depositors and institutional lenders, and then use the proceeds to purchase assets. The goal is to make more money from the assets and related fee income than it takes to run the operation and service debt.
It's for this reason that the balance sheet matters so much when it comes to analyzing a company like Bank of America (NYSE:BAC). Investigating the bank's balances gives you insight into its leverage ratio, the type of assets it focuses on, and the stability of its funding sources -- i.e., liquidity.
What follows are two key takeaways from a look at Bank of America's balance sheet.
Capital and leverage
In the aftermath of the financial crisis, capital became more important than ever. Not only have regulators increased the amount of capital that lenders must hold relative to their assets, but annual stress tests administered by the Federal Reserve determine whether or not the capital is sufficient to withstand a cataclysmic economic downturn akin to that of 2008-09.
There are multiple ways to measure capital adequacy, but the most straightforward is to simply look at a bank's ratio of equity to assets, as this will give you a good idea of how leveraged a particular bank is relative to its peers. In Bank of America's case, its ratio of 10.9% places it at the lower end of the spectrum.
Now, just to be clear, this isn't the end of the analysis. Not all capital is created equal; tangible capital like cash is obviously preferable to intangible capital like goodwill. Moreover, the quantity of capital that any particular bank should hold is in large part a function of the type and quality of its assets, as well as the bank's history of responsible risk management.
That being said, the simple fact that most banks are leveraged 10 to one should alert investors to the inherent risk of investing in bank stocks, as all it takes is a 10% diminution in the value of an average bank's assets to completely wipe out its equity base.
I think it's safe to say that when most people think about liquidity they think about liquid versus illiquid assets -- for instance, cash versus real estate. This is valid, but when it comes to banks there's another, arguably more important angle -- namely, the stability of their funding sources.
The experience of many banks during the financial crisis offers a textbook illustration of why this matters. While almost every big bank in the country was insolvent at certain points during the crisis, the reason institutions like Washington Mutual, Bear Stearns, and Lehman Brothers actually failed was because their funding sources dried up.
When it comes to banks, in other words, the concept of liquidity refers most pointedly to the composition of liabilities, or funding sources, and not how much cash they have on hand. And, to take this one step further, the best source of funding available is retail deposits, as these are the least likely to flee in the face of trouble -- though, of course, there are exceptions to this, Washington Mutual being one of them.
In this regard, Bank of America performs admirably. According to the FDIC's summary of deposits database, the Charlotte-based lender oversees the largest portfolio of deposits in the country. At nearly $1.2 trillion, it comfortably bests its closest big bank competitors JPMorgan Chase and Wells Fargo.
Beyond Bank of America's balance sheet
At the end of the day, a cursory glance at Bank of America's balance sheet shows that its overall capital base is small relative to those of many of its peers, but that it makes up for this in part by having the largest horde of retail deposits in the country.
Do these two things balance out to make Bank of America a buy? In my opinion they don't. While there's no denying the power of its franchise, it's also difficult to look beyond the bank's 30-year history of imprudent risk management. Ultimately, given the inherent risk in highly leveraged institutions, there's absolutely no reason to settle for anything but the best.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.