A few weeks ago, I came across this incredible opinion article from Matt LeVine on BloombergReview.com. In the article, he does an amazing and entertaining job breaking down Bank of America's (NYSE:BAC) third-quarter earnings.
The "too long; didn't read" version: Because of the ridiculously complex, esoteric, and conflicting accounting rules governing banks, it's darn near impossible to say whether B of A actually turned a profit last quarter or not.
To point out the obvious: That stinks for investors.
And the article only scratches the surface
As a bank stock analyst, this article really struck a chord with me, not only because it so appropriately describes the challenges of really understanding a bank's profits, but also because it barely scratches the surface of the complexity in modern banking.
Let's quickly look at leverage to further the point. As the banking industry is structured today, the leverage ratio most commonly referred to is the "Common Equity Tier 1 Risk-Based Capital Ratio."
Here's a chart of a few major banks and their Tier 1 ratios as of the third quarter:
|Bank||Tier 1 Common Equity Ratio Under Basel III|
|TD Bank (NYSE:TD)||9.30%|
|Wells Fargo (NYSE:WFC)||11.20%|
|Bank of America (NYSE:BAC)||9.60%|
On the surface, these institutions appear to be similarly capitalized. The problem, of course, is that the calculations to determine this ratio are ridiculously complex and distorting.
To prove it, let's now take look the leverage at these same banks using a far more simplistic ratio -- the assets-to-equity ratio.
Wait. What? How in the world is TD Bank's assets-to-equity ratio literally more than double these other three banks when their capital ratios are so similar? I honestly have no idea. The accounting is truly mind-boggling.
Here's an image of the formula used to calculate a bank's risk-based assets, a major component of the Tier 1 calculation. Keep in mind that this calculation is a component of another calculation. It's like a sadistic set of Russian nesting doll accountants.
Thanks to this formula, TD Bank is able to reduce its more than $900 billion in total assets down to just over $315 billion in risk-adjusted assets. That change accounts for the difference between what the table and the chart above show. That's the key to being considered well capitalized, while still having more than double the leverage of other, comparable banks.
In a perfect world, we would use a ratio as simple as the assets-to-equity ratio to measure just how levered a bank is. Despite some academic support for such a change, that's unlikely to ever occur.
Keep it simple, stupid
Does all this mean banks are a bad investment? I don't think so. I do think that this shows that investing in banks requires a fair amount more homework than investing in other, simpler businesses does. The reality is that no human being -- neither me, you, nor anyone else -- could ever really comprehend every nuance of the accounting required to produce a bank 10-K.
But even with other investments, the accounting rules are always going to be beyond the reach of the typical retail investor. That doesn't mean the businesses themselves are beyond comprehension. It just means that we, as investors, have to filter out the noise and focus on what really matters.
We still need to understand a business' fundamentals. We still need to read the SEC filings. We need to understand the risks, the opportunities, and how management is going to win in the marketplace. Focusing on what matters doesn't mean missing seeing the forest for the trees. The trick really is to keep it simple, stupid.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Apple, Bank of America, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.