There was a time when banks could do no wrong. Everything they touched would somehow turn to gold. It didn’t matter which bank we had invested in. It was like having a licence to print money.
Then everything changed in 2008. We woke up to the reality that banks could actually go bust. Consequently, bank shares were sinking faster than a hot soufflé meeting a blast of cold air. It was their own fault. Many had forgotten why they were there.
They were there to provide a safe place for savers to keep their money. Some of those savings could be lent out to reliable borrowers for a fee. That was how banks made their money. They paid savers a tiny bit of interest on their deposits and charged borrowers a lot more on their loans.
It is called the net-interest income. The wider the margin between interest earned and interest paid, the more money banks made.
However, banks weren’t supposed to put savers’ cash into risky ventures or lend to unreliable borrowers.
Some did, though. So, bank regulators had to step in to not only protect savers but also to regain their confidence.
The thing to remember is that banks are unavoidably exposed to the wider economy. Consequently, when times are good, they can make extraordinary amounts of money. However, when times are bad, they can be considerably less profitable, or they might even incur massive losses.
That is the price that banks are forced to pay. It is also the cross that bank investors have to bear when they invest in these types of financial institutions.
They are examples of cyclical businesses, inextricably tied to the economic cycle.
The point is that banks are an integral part of any economy. And trust in banks is paramount for any economy to function properly. It is also important to bear in mind that a bank’s solvency is based on its perceived solvency.
In other words, a bank is only as solvent as we believe it to be. If all of us decide to withdraw our money from a bank at the same time, then it is almost impossible for any bank, regardless of its financial strength, to satisfy all of our demands.
Look at what is happening to some Russian banks. The European subsidiary of one of Russia’s biggest banks is on the brink of collapse, as savers rush to withdraw their deposits. No bank can survive that kind of onslaught.
What’s more, the panic could spread to within Russia too, which could eventually bring down Russia’s domestic banks and, in turn, paralyse the entire Russian economy.
Banks, we need to remember, are not always the one-way bet that we might like to think they are. But they can still be a good bet for the long term if we choose the right ones. The challenge is finding the right ones to invest in. On that point, a bank’s financial statements is notoriously difficult to decipher, and it could be even harder to predict.
Just look at the recent results from Singapore’s 3 banks. Even though DBS Group (SGX: D05) posted a 37 per cent jump in fourth-quarter profit, it still managed to miss analysts’ estimates by a wide margin. OCBC (SGX: O39) also reported earnings that were below market expectations, but UOB (SGX: U11) managed to outfox analysts by posting better-than-expected results.
How could analysts get it so wrong? It goes to show that trying to forecast a bank’s performance is fraught with difficulties, thanks to the opacity of their operations. But there are a couple of metrics that are less impenetrable.
The price-to-book multiple is one of those metrics. By and large, the book value of a bank is a measure of its net assets at any point in time. We would expect the value of those assets to improve gradually over time, if it is a good bank.
The price-to-book metric is, therefore, a measure of how much we are prepared to pay for those assets. Obviously, the less we pay for them the better. But that means having the courage to buy when markets are at their most pessimistic and prices are at their most depressed.
Another metric is the dividend yield. The dividends that banks pay are tangible rewards for holding their shares. Consequently, the dividend yield can be compared to the interest rates on bank deposit accounts and bond yields.
Right now, the shares of a collection of well-known banks in Singapore are trading at a small discount to their book values over the last 5 years. Additionally, the dividend yields compare favourably with anything we could earn from bank deposits or from risk-free investments such as 10-year US Treasuries. So, is now a good time to buy bank shares?
That would depend on our outlook for the global economy. From what we can see, the recovery from the pandemic-instigated economic slump is underway. The crackpot in the Kremlin might delay the recovery, but he won’t be able to derail it.
Note: An earlier version of this article appeared in The Business Times.
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Disclaimer: David Kuo owns shares of DBS, OCBC and UOB.