Solvency Ratio

Liquidity Ratio

Leverage Ratio

Loan Growth

For many banks, loan growth is as important as revenue growth to most industrial
companies. The trouble with loan growth is that it is very difficult for an outside investor to
evaluate the quality of the borrowers that the bank is serving.

Above-average loan growth can mean that

 the bank has targeted attractive new markets

 has a low-cost capital base that allows it to charge less for its loans
 bank is pricing its money more cheaply
 loosening its credit standards
 somehow encouraging borrowers to move over their business.

Deposit Growth

As previously discussed, deposits are the most common, and almost always the cheapest,
source of loanable funds for banks. Accordingly, deposit growth gives investors a sense of
how much lending a bank can do. There are some important factors to consider with this
number. First, the cost of those funds is important; a bank that grows its deposits by offering
more generous rates, is not in the same competitive position as a bank that can produce the
same deposit growth at lower rates. Also, deposit growth has to be analyzed in the context of
loan growth and the bank management's plans for loan growth. Accumulating deposits,
particularly at higher rates, is actually bad for earnings if the bank cannot profitably deploy those
funds.
Loan/Deposit Ratio

The loan/deposit ratio helps assess a bank's liquidity, and by extension, the aggressiveness
of the bank's management.

If the loan/deposit ratio is too high, the bank could be vulnerable to any sudden adverse
changes in its deposit base.

Conversely, if the loan/deposit ratio is too low, the bank is holding on to unproductive capital
and earning less than it should.

Efficiency Ratio

A bank's efficiency ratio is essentially equivalent to a regular company's operating margin, in

that it measures how much the bank pays on operating expenses, like marketing and salaries.
By and large, lower is better.

Capital Ratios

There are a host of ratios that bank regulators and investors use to assess how risky a bank's
balance sheet is, and the degree to which the bank is vulnerable to an unexpected increase in
bad loans.

A bank's Tier 1 capital ratio takes a bank's equity capital and disclosed reserves and divides it
by the bank's risk-weighted assets, (assets whose value is reduced by certain statutory
amounts, based upon its perceived riskiness).

Tier 1 capital ratio = (Equity + Disclosed reserves) / RWA

The capital adequacy ratio is the sum of Tier 1 and Tier 2 capital, divided by the sum of risk-
weighted assets.

CAR = (Tier 1 capital + Tier 2 capital) / RWA (CR+MR+OR)

The tangible equity ratio takes the bank's equity, subtracts intangible assets, goodwill and
preferred stock equity, and then divides it by the bank's tangible assets. Although not an
especially popular ratio prior to the 2007/2008 credit crisis, it does offer a good measure of the
degree of loss a bank can withstand, before wiping out shareholder equity.
Tangible equity ratio = Equity – (Intangible assets + goodwill + Pref. stock equity) /

Tangible assets

Capital ratios can be thought of as proxies for a bank's margin of error. Nowadays, capital ratios
also play a larger role in determining whether regulators will sign off on acquisitions and
dividend payments.

Return On Equity / Return On Assets

Returns on equity and assets are well-established metrics long used in fundamental analysis
across a wide range of industries.

Return on equity is especially useful in the valuation of banks, as traditional cash flow models
can be very difficult to construct for financial companies, and return-on-equity models can offer
similar information.

Credit Quality

The importance of credit quality ratios is somewhat self-explanatory. If a bank's credit quality is
in decline because of non-performing loans and assets and/or charge-offs increases, the bank's
earnings and capital may be at risk.

A non-performing loan is a loan where payments of interest or principal are overdue by 90 days
or more, and it is typically presented as a percentage of outstanding loans. Net charge-
offs represent the difference in loans that are written off as unlikely to be recovered (gross
charge-offs) and any recoveries in previously written-off loans.
Net interest margin (NIM)

A bank’s main source of income is the difference between the interest received from the
customers it has made loans to and the amount it pays its depositors and other providers of
debt funding. This is known as the ‘net interest margin’ and is typically expressed as a
percentage of the average loans (or ‘interest earning assets’) outstanding over the period in
question. While not part of the official financial statements, most banks disclose this average
somewhere near the front of their detailed annual reports. Table 1: Net interest margin Bendigo
and Adelaide Bank to 30 June, 2009 a) Interest received $3,213.4m b) Interest paid $2,578.4m
c) Net interest income (a–b) $635.0m d) Interest earning assets $45,336m e) Net interest
margin (c/d) 1.40% Table 1 shows how the numbers came together for Bendigo and Adelaide
Bank in year to 30 June 2009. The long term industry trend in Australia has been towards lower
net interest margins as non-bank lenders like Aussie Home Loans, RAMS and Wizard brought
more competition into the mortgage market. And while the financial crisis exposed the
weakness of those alternative business models and effectively removed them from the market,
margins are now under pressure from higher funding costs (a result of a war for deposits and
higher costs from offshore borrowing, see Our big banks’ Achilles’ heel for details). The trend
towards lower net interest margins throughout the 1990s and most of the past decade was more
than offset (from a profit point of view) by rampant growth in the amount of loans outstanding
and in the fees banks charge to customers. But with credit growth slowing markedly and fees
under pressure, net interest margins will need to stabilise or increase if bank shareholders are
to enjoy meaningful profit growth.

Cost-to-income ratio

Taking the net interest income and adding the non-interest income (aka ‘fees’), we arrive at a
bank’s total income (though, in practice, there are often a few ‘other’ items to account for). The
cost-to-income ratio (or ‘efficiency ratio’) takes the bank’s operating expenses as a percentage
of its total income. The lower, the better. Table 2: Cost-to-income ratio Bendigo and Adelaide
Bank to 30 June, 2009 a) Net interest income ($m) 635.0 b) Non-interest income ($m) 306.3 c)
Total income (a+b) ($m) 941.3 d) Expenses* ($m) 614.0 e) Cost-to-income ratio (d/c) 65.2%
*Excludes significant items It’s important to note that this is purely an operational measure. It
excludes any losses from bad debts. Table 2 shows the relevant figures and calculations for
Bendigo and Adelaide Bank in 2009. As technology has marched forward (telephone banking,
ATMs and now internet banking), banks have done a great job of pushing this ratio lower. There
was a time when a cost-to-income ratio of 60% was seen as ‘best practice’. Nowadays the more
efficient big banks are getting down below 40%. Bendigo and Adelaide’s smaller size and
community focus mean it’s never likely to be an industry leader on this measure.
Bad debts

Charging fees and receiving interest is all in a day’s work for the average banker. But things
occasionally turn ugly when a client can’t meet their repayments and a debt goes bad. And
when you’re dealing with a net interest margin of less than 2%, it doesn’t take many bad loans
to wipe out a hefty chunk of your profit. Table 3: Bad debts Bendigo and Adelaide Bank, 30
June 2008 2009 Bad & doubtful debts charge ($m) 23.1 80.3 Net impaired loans
($m) 37.8 156.7 Gross loans ($m) 40,258.3 38,923.1 Bad debts charge/Gross
loans 0.06% 0.21% Net impaired loans/Gross loans 0.09% 0.40% Bad debt charges can be
tracked in a number of ways. You could simply line up the numbers charged off in each
individual year but these are better viewed in perspective against the size of the loan book. In
Table 3 you can see Bendigo and Adelaide’s annual charge for bad and doubtful debts, as well
as the total impaired loans, as a percentage of its closing loan book for both 2008 and 2009

Tier 1 capital ratio

This is the primary yardstick employed by regulators (and analysts) to measure a bank’s capital
strength. Calculating the ratio firstly involves figuring out the amount of ‘tier 1 capital’. This is the
highest quality capital from a regulator’s perspective; that’s the capital that is readily ‘losable’,
such as shareholders’ funds, certain reserves and some hybrid securities. This figure is then
taken as a percentage of ‘risk-weighted assets’ (rather than total assets). This risk-weighing
process acknowledges the reality that an unsecured loan to a risky gold explorer is a vastly
different proposition to a residential mortgage well secured against a property. So the regulator
applies different risk-weightings to various classes of loans and the tier 1 capital is then divided
by this risk-weighted asset base. Table 4: Tier 1 capital ratio Bendigo and Adelaide Bank, 30
June 2008 2009 a) Total tier 1 capital ($m) 1,491.7 1,793.7 b) Total risk-weighted assets
($m) 19,820.8 24,155.0 c) Tier 1 capital ratio (a/b) ($m) 7.53% 7.43% Following the global
financial crisis, banks have generally been preparing themselves for tougher regulation by
boosting their tier one capital ratios. As a rule of thumb, 8% might once have been considered
‘normal’, but it’s difficult to generalise because of the clear global trend towards banks holding
more capital (and thus having higher tier one capital ratios). Bendigo and Adelaide raised
$300m after 30 June 2009 and, not surprisingly, chose to report its tier one capital ratio as
8.63% in the glossy section of the report to shareholders; as if that money had already been
raised at 30 June (‘on a ‘pro forma’ basis). The tier 1 capital ratio had risen to 8.95% by 31
December, a figure consistent with most of Bendigo and Adelaide’s larger competitors in the
current environment.
Pricing measures

One has to be careful applying common pricing ratios like the price-to-earnings ratio (PER) and
dividend yield in assessing a bank stock’s attractiveness. The problem is that bad debts or one-
off items can knock around any given year’s profit. And, in boom times, the dividends can
become unsustainably high, as bank shareholders learned the hard way in 2007 when their
dividends were cut and they were hit up for additional cash to shore up the bank’s capital. So if
you’re looking to apply a PER or dividend yield, you must first consider whether the profit and
dividend figures you’re using might be unusually high or depressed. To alleviate that challenge,
we like to look at the price to book value ratio. This isn’t a perfect measure on its own as it
needs to be assessed in conjunction with the bank’s profitability (in terms of return on equity).
The higher you expect a bank’s return on equity to be, the higher the multiple of book value you
would be inclined to pay. Table 5: Return on equity and price/book Bendigo Commonwealth
Return on equity (cash basis) 5.8% 15.8% Price to book ratio 0.77 2.43 As a guide, if we
thought a bank (or any company, for that matter) was likely to earn a return on equity of 10% or
less over time, then we’d demand a price to book value of less than one to compensate for
those low returns. Whereas a company earning more than 15% on its equity might be worth two
times its book value or more, depending upon how much growth might lie ahead. This might
sound quite arbitrary but if you spend some time comparing the returns on equity and the price-
to-book ratios both within an industry and between industries, you’ll begin to develop a feel for
the usefulness of this approach. Compare Bendigo and Adelaide Bank’s return on equity to
Commonwealth Bank’s and you can see why investors pay a higher price-to-book ratio for the
latter (see Table 5).