Proposition 1: When you buy into a bank with your own money, you buy into a highly leveraged situation. That’s because banks employ huge amount of leverage. This leverage will magnify your returns – both positive as well as negative.
Proposition 2: When you buy the shares of a debt-free business with your own money, there is no use of leverage at your or the portfolio company level. But you can do a thought experiment and imagine that you brought into this debt free business with borrowed money and then calculate the expected return on your money.
If you don’t make that adjustment, you are comparing apples with oranges which doesn’t make sense to me. For me, to be able to buy into a bank I love, the expected return on its stock should be materially higher than the expected return of owning a debt-free business that also I love. But, if such an adjustment ensures that I will almost never buy a bank then so be it.
It’s important to recognize that (1) leverage affects returns no matter where it resides (at the portfolio level or at the portfolio company level); (2) leverage adds to investment risk; and (3) investors should seek significantly higher returns to compensate for additional risk that leverage adds to the portfolio.
Fundoo Professor 
Hi Prof,
I agree with your argument at a conceptual level. For practical purposes though one should also consider the following:
1. Leverage is just one of the risk factors. There are plenty of value destroying businesses that don’t employ leverage.
2. The leverage employed by a bank is quite unique. Much of it comes from customer deposits which are quite sticky unless there is a run on the bank ( mostly mitigated by government insurance on deposits).
3. Banks by virtue of their position granted to them by the regulatory authorities can deploy their funds to generate virtually guaranteed returns ( unless they make stupid lending decisions) in ways that ordinary individuals cannot.
4. Well run banks have been one of the best shareholder value creators over the long term in most countries.
Bobby
I am not so sure about the 4th point that banks are one of the best value creators among companies .
Hi sanjay
What if the leverage in a bank is similar to the float of a well managed insurance company ? aka customer deposit which though a liability is actually an asset ?
i think buffett has mentioned the same point when discussing banks in the following article
http://archive.fortune.com/2009/04/19/news/companies/lashinsky_buffett.fortune/index.htm
You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on.
This is very interesting thought.
Thanks for the post, Sir!
A thought on your last point – (3) investors should seek significantly higher returns to compensate for additional risk that leverage adds to the portfolio.
How does one seek higher returns out of a leveraged position? Isn’t it only known in hindsight that leverage helped magnify gains?
And if this actually happens i.e, leverage magnifies returns, an investor would start to believe that because his outcome was good, the process and decisions made to arrive at that outcome must have been sound.
Isn’t this a situation when the investor forgets ‘alternative histories’ (what could have been), and takes even bigger risks in the future?
Regards,
Vishal
Vishal, when you buy a bank, you have focus a huge amount on the quality of the management. Take, for example, what Mr. Buffett wrote in his 1990 letter:
“The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the “institutional imperative:” the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.
Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing
shares of a poorly-managed bank at a “cheap” price. Instead, our only interest is in buying into well- managed banks at fair prices.”
In fact anytime there is a lot of leverage in the system, you have to think very deeply about the quality of the management. Once you have made that assessment and have come to the conclusion that the management of the bank you are contemplating investing in is a fabulous one, then in your judgement, the presence of leverage will be beneficial for you. Now, there is no bank stock investor who thinks that the management of the banks whose stocks he owns is lousy. But, it turns out that many of them are wrong. But some of them are right.
The point I am trying to make is that even if you are right about your assessment that the management is fabulous, you must still recognise the role of leverage in your total expected return from that stock. And one way (the way I like) is to compare it with hypothetical leveraged returns from debt-free businesses which also pass all my other filters.
Other things remaining the same, if the leveraged return on an un-leveraged business is far higher than the unleveraged return on a leveraged banking stock, I should prefer the former, because the decision to leverage my return always vests with me. In effect, I can always create my own “bank” by borrowing against the collateral of shares of un-leveraged, desirable businesses.
Hi sanjay
To add to my previous comment, the proposition breaks if the leverage – customer deposit is like a long term float which keeps growing and is never paid back. If however the trust is lost, and we have a run on the bank, then all bets are off. An equity investor will lose almost all his money – similar to what happened to AIG, Lehman and other bank investors. So there is a non zero probability of ruin
rgds
rohit
That’s an excellent point Rohit. Not all forms of leverage create the same type of risk. The risk from leverage in the form of a high-quality float is very different from the risk of having large current account deposits in a bank’s capital structure. Similarly, the use of “other people’s money” in money management business is not anywhere as close to risky for that business as borrowing short-term money from a bank.
My post was directed towards banking stocks because I meet investors who talk about the returns earned in some high-quality banking stocks, without referring to the role of leverage in delivering those returns and without ever referring to the possibility that people could have earned far higher returns by borrowing against the shares of high-quality, debt-free businesses.
I see the same faulty logic when I hear people talk about the returns they made in real estate. They forget that a very large part of the return on their money came from borrowed money which cost less then the un-leveraged return on the real estate asset.
Sir I believe Real Estate has been given lousy returns even when leveraged…..
My friends dad bought a piece of land at Rs. 3 lakh which is now worth 1 Cr. He oftens cites this example to show how good RE returns can be. When I mentioned it to him that in 27yrs, money grown at 25% today should actually be worth 20Cr, he went dead silent.
People like to focus on the quantum of return and not on the Rate of return.
Also matters is what kind of discretion does the management has in using the float. The float generated in BH is on complete discretion of WB, who is able to generate outsized returns for long periods of time.
NIM of HDFC is 4% whereas BH generally has produced just underwriting profits of more than 5%, add the investment return to that figure. The NIM for BH was & is way above banks, that is also a moat and changes the equation a lot.
Sir,
When you mention Banks, do you also include NBFCs in the same category?
If we take an example of say Gruh Finance, Isn’t it materially different?
1) It is loaning small amounts to very large number of customers (<10 Lakhs) who are geographically distributed over large parts of the country.
2) Even the loan is against the property where owner has some equity (20% or more)
So the above example is materially different from a bank giving large loan to Kingfisher or DCHL.
Regards,
Vamsee
Prof. Unlike a company that levers itself to build a single asset, the leverage of a bank is spread across :
– multiple assets – retail, corporate etc. and that provides a natural diversification
– the recourse methods and recovery methods again are spread out and is helped by “endowment bias” of the borrowers (provided you’ve chosen good quality borrowers) who prefer to pay off the amount given the societal, social and emotional costs involved of getting separated from the asset they bought with the levered money – case in point, people continue to pay EMI’s in places where property prices have fallen 50% because they want to be good citizens.
– most banks have a regulator who keep a hawk eye over their operations which is also a threat – in case the regulator gets subject to the same type of thinking as banks do ala sub prime crisis in 2008
To sum up, I think they are a notch lower in risk than a levered asset purchase/levered acquisition definitely. Banks that prefer to jump over “one foot hurdles” by making prudent spreads tend to do much better in the long run – case in point HDFC vs icici bank.
Pat Dorsey talks about how Banks have an in-built moat (may be a narrow moat) by making it difficult for customers to switch. One can go and start a retailer very easily but starting a bank is regulation-heavy.
It is a given that not all banks are equal. So given a choice of investing in a speciality retailer or a well-run bank, which in your thoughts would be a better investment in long run (25+ years) ?
Say, instead of a bank we choose a housing finance company – Gruh, Repco, HDFC. Won’t the quality of leverage significantly favour the lender? For instance if a flat costs Rs 1 cr, the buyer would have paid at least 30 per cent in ‘black’. Of the rest, the HFC would fund only 90 per cent maximum. How much protection it would give in a deflationary environment is the big question since India we have never seen deflation.
Interesting Point Sir! Leverage in the banking business is a double edged sword!
Can a consistently well managed leverage become a source of moat for a bank? Should we see Berkshire’s investment in ‘Wells Fargo’ bank on similar lines?
Regards
Ravi Shankar
Hello Prof
A few points from my side:
– It is a great point to compare leveraged return of one company by thinking of creating leverage on your side for an unleveraged company and then deciding. However, I would think that as with any comparison this is only useful in similar industry. So I would assume that the above point is more within banks or may be to some extent including NBFCs.
– Leverage magnifies everything – both good and bad of the business and management. However, Buffett has had a very high strike rate with his investments in banks (not sure if Mohnish Pabrai had mentioned it in one of the talks). So if one can find some good opportunities in Banking space with a good management it can be a wonderful business to own for the long term even though leverage introduces additional risk.
Regards
Rajeev
Hi Sanjay
Just a thought —- When we borrow money to buy stock of a debt free company, it is recourse debt. When it resides on the balance sheet of the portfolio company, it is non-recourse debt for the investor. Does it not cap the downside for an individual investor? If so, is it not safer to have non-recourse or non-encumbered source of debt to the extent that we want to lever our portfolio?
Balaji
http://www.beowulfcap.com
Honourable people pay their debts whether they are recourse or non recourse. I don’t think one’s downside is limited in case on non recourse debt if one considers reputational loss because of default.
Sir thanks for sharing your insights ,
but as an independent learning investor what to look in a bank
-means one is the cost of deposits like how much is CASA ratio,stickiness of CASA becuase of people taking pain to shift their account from 1 bank to other , easy of doing transactions, not institutionally bidden to do non profitable work -like psu needs to open account for so many scheme ,where cost of opening an account is more than the business and saving deposited by customer)
than leverage factor
than quality of lending in terms of where they are lending ( like HDFC bank vs Yes bank)
but these are the good factor , but after learning from you Invert always Invert
what bank to avoid -by what factors
this I am not able to figure out -need help of yours
like taking a specific example
J&K Bank for me that bank -looks good sounded on basis of taking max share of govt treasury activities for the state and local deposits
but as they don’t have much lending opportunities in J&K
they lend outside and their record is not good -HDIL…
but their is a positive opportunity in terms of political stability and than growth generated from that , where they will be major beneficiary in terms of getting more business
But I am not able to still figure out -what negative factors to look to deselect a bank for investing
Thanks again for sharing your lecture, I remember we requested many times in past and now finally we are able to get a gist of your insights
Regards
Prof, many thanks for posting this. Slightly related, can we mitigate this risk by buying, say a Bank ETF? The idea being that if the economy does well, banks should do well, but pinpointing which specific bank will do well is slightly a black art since it’s quite hard to figure out the sectors they are exposed to and the sectoral risk among other things.
The point I’m trying to make is that while a few banks will certainly collapse because of leverage, the banking industry is definitely not going away and should prosper with the people who bank with the bank.
HI Prof ,
I have a different take on the same .
1) All deposit should be treated as Raw material that is being converted into finished goods ie loans : So just like we don’t add raw material cost to long term debts in mfg company you should not do the same in banks . Imagine if we had done this to all mfg companies which have PSR ratio below 1 in 2009 , it would have been impossible to justify many investments .
2) Hence the one of few critical metric in Bank is NIMs and NPAs ( just like OPMs and Receivables T/O in mfg company ) ie how well raw material is utilised and finished goods sold
3) Regarding Loss of trust and customer pulling out money , it can happen to any company incl mfg when suppliers refuse to give credit and buyers refuse to pay receivables .
Excellent outlook.
Dear Shailesh my two cents : When we compare banks to mfg companies raw material cost is “interest to be paid on deposits” and not deposits themselves. Similarly the finished good is actually the interest to be received on loans and not loans themselves. But earning this interest spread involves playing with large sums of money which if not well managed could become NPAs and eat in to all interest spread and even shareholders’ equity.
Professor, Banks also earn other income [I am primarily referring to those earning Fee Income(ranges from 20% to 40% for pvt banks) and not Trading income] these are like toll taxes/fees. With so many millions of transactions, the facilitator i.e. the banks acts as toll collectors and I only expect this to keep increasing unless the consumer wises up.
The point that’s not considered here is leverage in concentrated form or in diversified form. Banks are supposed to have it in diversified form; that’s where Bank’s risk management comes in and there HDFC Bank commands premium as loan portfolio is majorly for retail loans.
If risk in banks so diversified as you claim, then why do we have so many bank failures? You can’t use HDFC Bank as an example to illustrate the risk in banking…
Hi Prof,
While both involve the use of leverage, would you not agree that the purpose of leverage also influences the inherent risk? A bank uses leverage and primarily lends the money, many times with collateral. If i leverage and invest as a shareholder, are the risks not different?
To put it differently, a bank is nothing but a trader of money, taking money from the investor/depositor and onward lending to say M/s ABC Ltd. Let us say that you have leveraged funds and
Scenario 1) Invest in FD of M/s ABC Ltd (thereby eliminating the bank or the trader)
Scenario 2) Invest in equity of M/s ABC Ltd
Are the two risks not different?
If i now include the trader (bank) in the above equation and invest in its equity and allow it to leverage on my behalf, should now my risks become comparable?
In my view the fact that use of the leverage by a bank is primarily towards investment in fixed income securities renders the risks incomparable.
When i apply your thought experiment to a PE/Equity based Mutual Fund which are also intermediate vehicles but invest in equity and not debt, it makes sense but am not able to seamlessly apply it to a bank. Would hugely appreciate if you could clear these doubts..
Regards
Abhinav Mansinghka
Sir, isn’t ‘leverage’ for a bank similar to ‘raw material’ for a non banking company? In my view, not all kinds of leverage are risky. In the case of banks, it is the raw material for their business and if soundly managed, does not create additional risk than that in the case of a non banking sector company. As Rohit Chauhan has mentioned in previous posts, the form of leverage (for high quality banks – akin to float) is also important to consider. To my mind, in such cases leverage is not necessarily equal to higher risk wherein an investor would want to seek higher returns. The risk for a top quality bank (say HDFC Bank) is almost the same as that in the case of any other top quality company from another sector.
If leverage was similar to “raw material,” as you put it, then it’s quite a toxic one given the history of bank failures. If you make a list of debt-free companies that went bust and a list of banks that failed, then the second list will be a much larger list. I would also argue number of banks that fail as a percentage of total number of banks would be much larger than number of debt-free businesses that fail as a percentage of all debt-free businesses.
As a class (think baseline information), banks are far more risky than debt-free businesses. Accordingly, investors should see an extra return to invest in them.
To add to my previous posts – a non banking company taking on debt to grow/ manage working capital/ fund losses may be riskier than a bank whose basic business model is to earn on the spread between leverage and lending.
https://www.youtube.com/watch?v=2tDgcmKSgTc David Einhorn looks for one bad financial institution every year and shorts it .This is leverage square .
Great video! (The example of Allied Capital)
Thanks for sharing Haresh bhai
Hi Prof,
If we bring the concept of homemade leverage into the fold for comparing a bank with a normal business, we are indirectly comparing the RoA of the banking business with that of a non-banking business which will always skew the decision in favor of non-banking business.
But Isn’t the leverage at the bank’s balance sheet level a lot different than a leverage at the portfolio level for non-levered company? Because the thing that can kill a bank are controllable to an extent in hands of management. But the leverage at non-levered company level is exposed to market risk disproportionately for an investor. In a way, bad conditions may impair a good bank but will kill the levered guy due to margin call.
Thanks for starting an interesting discussion and making us think in a different direction!
Regards,
Utkarsh
This is a superb point Utkarsh. As I reflected on this, I realised that one should compare the expected return on the stock of a bank with the expected return on the stock of a debt-free business (by assuming moderate amount of debt on its balance sheet). If one makes that adjustment,then one can effectively lower one’s “cost of acquisition” by mentally withdrawing the capital raised by debt as a dividend and then estimate the expected return on the “reduced” investment.
The above thought experiment forces one to think like a businessman who can pick between two choices: (1) buy an admirable bank at its current market value; or (2) buy an admirable debt-free business at its current market valuation and finance part of the purchase price with moderate amounts of debt.
If you want, I can do a call to explain this to you.
Also, you point that my earlier comparison will “always skew the decision in favor of non-banking business” is not correct because I am not comparing ROA’s but expected returns and the latter are influenced by valuations. If, for example, HDFC Bank became available at a alight premium over book value (and I am dreaming here) then, assuming no change in its future prospects, its expected return could far exceed that on a debt-fee business I love, in which case I should prefer to buy the bank stock.
Thanks Prof for the reply.
It makes a lot of sense to bring the companies across sectors at similar risk levels when thinking from an expected returns perspective.
I’m trying to work it out with practical examples and where I’m confused is what level of debt is moderate levels of debt? At present, I’m thinking of qualitative factors which leaves a lot of scope for existing biases and primarily the fact that levering the debt free business, giving dividends isn’t increasing much risk either due to the nature of business and stability of cash flows. The quantitative ones like bringing betas to similar levels by playing with D/E ratio are doable and quantitative but conclusions might not be practical.
Eventually, one may end up as taking a part intuitive call. But thinking along these lines will surely make those calls more rational !
Regards,
Utkarsh
Utkarsh
I agree with you that making a workable practical model adjusting for the leverage factor in banks to bring them on the same seem comparable with a debt free business is quite complicated.
The major problem that I see here is with “What comprises of Debt?”
Should deposits made by customers into their savings accounts at a bank be treated as debt ?
If we decide to treat all short term and long term borrowings as debt, the debt ratios we arrive at for banks will be stratospheric.
eg: HDFC bank has a D/E of 9 times, ICICI bank’s D/E stands at 7.5.
If we decide to go with a narrower definition of debt, we have to decide what to
include in debt and what to exclude, with all of its subjective components. Thus, we can
decide to include only long term debt and end up with more reasonable looking numbers, but there is no logical rationale for the choice.
Another problem I see is wrt the difference in valuation models employed :
Re-investing profits back into business and generating much higher incremental free cash flows is the attribute of a great business like Relaxo which prof has talked about earlier in detail.
DCF is one of the commonly used valuation models to estimate the future cash flows.
Unfortunately estimating net capex and working capital requirements for a bank is highly difficult. Unlike manufacturing firms that invest in plant, machinery etc, financial service firms invest primarily in intangible assets such human resources and branding. Hence, their investments for future growth often are categorized as operating expenses in accounting statements. That’s the reason we see show little capital expenditures and correspondingly low depreciation in their cash flow statements.
Hence DCF is impractical in such cases and one has to look for some other valuation model for banks.
When all our valuation models are built on many assumptions and estimations, and when we are using different models to calculate the fair value of these two businesses how can you extrapolate them onto a measurement scale and choose the better investment from an expected returns perspective.
It would be great if Prof Sanjay Bakshi can provide us a framework to do this.
Thanks & Regards
Ravi Shankar
Hello Prof Bakshi,
An excellent post again. It is always a pleasure to read your blog posts as they are a wealth of information.
On this post, I somehow have a different opinion. Banking or any lending business to me consists of the following five steps;
1. Borrow cheap
2. Lend High
3. Ensure that the money you lend out is collected
4. Ensure that the cost in lending and collection is as low as possible
5. If the above is working, do more of the same, grow
You basic assumption is that the point number one is not being fulfilled in this case. If we were to imagine that if the cost of borrowing were zero and as others have pointed out that there is no run on the bank, the whole question of leverage disappears. All of this is predicated on point no 3 which is that the management is sane and exercises due caution when lending out the money.
What if people came to deposit money into banks only for safekeeping and not to earn an interest. Not very dissimilar to what is happening in parts of Europe and Japan. Will you then still have reservations about investing in banks? What if an European bank was smart to raise money in Europe at zero interest rate and lend it at 8% in India with no exchange rate risk and no default risk. I know this is utopian but something akin happens in the world all the time.
To me the greatest characteristic of any business is to raise prices without losing customers. Provided all the other operational costs remain the same, the return on equity for this incremental profit is infinite as no new capital was invested to get this additional income. I think that banks are in the position to pass on the increase in the fund costs to the customers without losing them to some other franchise.
Here is an interview from 2009 when Warren Buffet was investing is Wells Fargo and nobody would touch banks with a barge pole.
http://archive.fortune.com/2009/04/19/news/companies/lashinsky_buffett.fortune/index.htm
Best Regards
Piyush
Hi Prof ,
Are you forgetting something ? Warren Buffett the world’s richest investor has huge holdings in Well Fargo and AMEX . Both of which have given him excellent returns .
So while what you say is conceptually ok , in practice it is not right to paint all banks with the same brush . Some of the banks are as good as non-banks in wealth creation .For eg. I would rank HDFC Bank at par with Asian Paints for superior long term returns .
Regards ,
James
[…] Sanjay Bakshi on the use of leverage and its connection to risk and […]
Hi Prof,
People have made a lot of money in the banking sector so far in India. However I totally agree this is a sector where risk is very high. As the leverage increases risk increases – what ever be the quality of management. As such one has to look for higher returns when investing in such business. However the current valuation of Banks in India is very high and that leaves us with a lot of risk without opportunities for long term wealth creation. With regard to investments by Warren Buffet – if one studies his Bank investments – they are very calculated risks and in only a few Banks. This Banks ie Wells Fargo and AMEX have different business models vis a vis Banks in India. Also US credit scenario is different ball game altogether.
As such it makes sense what the Prof is saying. Also we must not forget the NIMs in India are way too high and can only go down in the years to come.
Regards
Gaurav
Dear Professor,
I would say, to invest in a Bank one has to understand the banking industry, in the same way as to invest in Page Ind one has to understand the garments industry.
What I mean is that a Bank is in the business of leverage. Their raw material is money. Their output is (money + interest) and fees. So a good bank is one that understands opportunity sectors, lending risks, and collections. It has to source money cheap, from wholesale loans, CASA and deposits. Ensure capital adequacy. And generate NIMs and fees for services. Its a knowledge industry. There are NPAs, which can be tracked.
I feel its no riskier than any other sector.
In other sectors the leverage per se may not be that important. Its not the raw material, only the means to set up additional capacities, and balance cash flow and credit requirements. So many non leverage ratios need to be monitored specific to the industry to assess the company. Its just different.
Just my two cents.
Regards, Punit Jain, Founder JainMatrix Investments.
While banks are in the business of leverage, investors are in the business of allocating capital wherever they find the best risk-adjusted returns…
I have referred to the “raw material” argument in one of the other comments…
Hi Sanjay sir,
Would it be prudent to paint the entire banking industry with the same brush as we paint other highly leveraged companies. Banks enjoy many advantages that are would be the envy of other industries, such as high barriers to entry and strict regulations which do not leave much scope for new players to come in or for much disruption.Combine this with the fact that the banking industry is regarded as a pillar of the economy and banks too important to be allowed to fail.
I fully agree with the premise that banks employ huge amounts of leverage and hence are highly risky, but as one of your ex students I cannot help but think from a behavioral finance perspective. What about the incentives of various authorities and the government that will keep the bank going even at a stage at which companies in the other industries would not survive? A strong banking system reflects the strength of the economy and a strong economy serves the interests of those in power. Does this not uniquely place the banks to do better than other industries?
Regards,
Fahd
Syed, I am not painting the entire banking industry with the same brush. I fully appreciate the quality of a moat a banking licence can bring. There are admirable banks which would easily meet the business and management quality tests. But then, so are many debt-free businesses. Which one to choose? If the stock of an admirable bank offered you an expected return of 20% p.a. over the next ten years and that of an admirable debt-free company offered you an expected return of 19% p.a. over the next ten years, I would pick the stock of the debt-free company.
The post offers a framework which can be used to compare the two situations appropriately by introducing an element of modest leverage in the debt-free business.
Hi Sir. Want to put across a point that cost of funds of banks are quite low to create a leverage. However, if I want to create leverage using borrowed funds or by pledging the shares of a debt free company, my cost would be definitely higher. Request your views on the same.
Hi Sanjay,
Very interesting point, and I’m no fan of banks today for different reasons (the downside now is far more than the upside) I’d like to add:
1) Banking is highly leveraged by its nature but also highly regulated. In that context they have access to money that, well, no other entity has – the RBI will willingly create money to lend to a bank in case the bank has trouble getting that money elsewhere.
However in the case of a real default the shareholders will be the first to take a hit. (and we havent had one since GTB where shareholders lost money) Leverage means shareholder equity has to take the first hit, though in many banks there will be rescue attempts involving adding more capital which hurts….existing shareholders.
2) Banking has the element of surprise in the form of backstops by the government, mostly implicit.That’s why a bank like United Bank of India gets away despite having nearly 10% of its loans as NPAs which wipes out most of its capital, still survive because everyone feels the government will rescue it. A rescue will simply mean diluting other shareholders substantially (and the government has no cash, but that’s another issue) – but no one seems to care, and the stock still trades as if it were a functioning bank.
3) These two factors – RBI emergency lending and government backstops – makes banking seem less risky than it is. Therefore return expectations are lower, especially in eras of lower interest rates, where banks are seen to be money making machines.
But the sad problem really is that risk isn’t visible in the banking system for a very very long period of time. So one gets this sense of complacency, which only means investors don’t mind lower returns….
Utkarsh
I agree with you that making a workable practical model adjusting for the leverage factor in banks to bring them on a comparable track (wrt expected returns) with a debt free business is quite complicated.
The major problem that I see here is with “What comprises of Debt?”
Should deposits made by customers into their savings accounts at a bank be treated as debt ?
If we decide to treat all short term and long term borrowings as debt, the debt ratios we arrive at for banks will be stratospheric.
eg: HDFC bank has a D/E of 9 times, ICICI bank’s D/E stands at 7.5.
If we decide to go with a narrower definition of debt, we have to decide what to include in debt and what to exclude, with all of its subjective components. Thus, we can decide to include only long term debt and end up with more reasonable looking numbers, but there is no logical rationale for the choice.
Another problem I see is wrt the difference in valuation models employed.
Re-investing profits back into business and generating much higher incremental free cash flows is the attribute of a great business like Relaxo which prof has talked about earlier in detail.
DCF is one of the commonly used valuation models to estimate the future cash flows in businesses like Relaxo, PAGE Industries, HUL etc. Unfortunately estimating net capex and working capital requirements for a bank is highly difficult. Unlike manufacturing firms that invest in plant, machinery etc, financial service firms invest primarily in intangible assets such human resources and branding. Hence, their investments for future growth often are categorized as operating expenses in accounting statements. That’s the reason we see show little capital expenditures and correspondingly low depreciation in their cash flow statements. Hence DCF is impractical in such cases and one has to look for some other valuation model for banks.
When all our valuation models are built on many assumptions and estimations, and when we are using different models to calculate the fair value of these two businesses how can you extrapolate them onto a measurement scale and choose the better investment from an expected returns perspective.
It would be great if Prof Sanjay Bakshi can provide us a framework to do this.
Thanks & Regards
Ravi Shankar
Ravi,
Even though I do not have any valuation model or framework for valuing banks, I have an approach and would like to use it to answer your question
1.In my opinion, deposits should be treated as debt. By definition, any interest bearing liability should be treated as debt. Hence, deposits being interest bearing liabilities should be treated as debt. Or alternatively, thinking in terms of ‘functional equivalents’, a concept I learned during Prof Bakshi’s class, CASA deposits may be replaced by bonds issued by a bank, with the face value of Rupees 1 and with a put option that it can be redeemed anytime by the buyer of the bond. Since, it has a put option, it pays lesser interest than a normal bond. Now if it is non traded, then the only way to get your money back is to redeem the bond. We can have fixed deposits in the same manner. Now if we assume that the costs of the the transaction for such bonds are same as for deposit, and voila, we have converted the entire deposit base into a more conventional form of debt.
2. The use of DCF or any other valuation model for valuing a bank:
Firstly, I believe using DCF or any such method to value a bank or any other company is a classic case of what Charlie Munger calls as “Physics envy”. By putting in some assumptions the model works beautifully and churns out a precise number. Given the human tendency to avoid uncertainty, we accept the process as scientific, the beauty of the model, blinding us to what errors could have crept in because of our biases.
Secondly, the DCF works only when we assume that at some point of time the firm has excess cash to give out to shareholders, this excess cash being excess of what the company needs to maintain as well grow its business. A bank similarly has to satisfy regulatory capital norms. Hence a growing bank can never throw out excess capital in the form of cash. It might, but then it has to keep raising capital as well. And even if it has excess capital, it needs to maintain sufficient buffers to protect against any downturn, given the highly leveraged nature of the business, where one bad year can wipe out profits earned in the past many good years. It may eventually have enough surplus capital to pay out after many years but the accuracy of any model decreases as we go forward in time, so using a DCF model might not be the best approach.
3. How to value a bank
As already stated I do not have any model, but an approach which I would like to share
First, Given the highly leveraged and risky nature of the banking business, it could be classified as fragile (borrowing Nassim Taleb’s definition)
Hence, I believe the best investment candidate would be, and again borrowing the phrase from Nassim Taleb, Anti Fragile (Could be understood as an option with limited downside and unlimited upside/ things which do better under stress)
Now, the issue at hand is to know if there are any banks, which could be said to be antifragile (though given the nature of the business, only very few would make the cut)
I think that evaluating the bank’s management would be the best way to judge whether the bank can be said to be Anti Fragile. And the quality of the management would show up in the numbers of the bank. I believe the best banks would be those which are proactive to recognize, provision and write off bad debts, regardless of the hit to their numbers. A bank whose management does not get carried away in the good times, does not give in to envy, even if its peers are making easy money lending to risky businesses, proactive in raising equity, maintains capital buffers well in excess of regulatory requirements, which would give them a margin of safety.
Such banks I believe can be to some extent classified as Anti Fragile, as these are expected to do better under stress. During downturns, when other banks are bogged down they can continue to do business and when the economy picks they are the strongest amongst their peers in terms of ability to lend. Even if their stock prices take a hit, their businesses won’t, and hence any such bank which satisfies this criteria is, I believe a good investment candidate.
Request Prof Bakshi to kindly share his views on the above
Regards,
Fahd
My thought – investing in bank equity becomes sort of like a negative black swan trade. You could (in theory) expect the bank to grow its equity very regularly and get a nice return with falling rates, high NIM’s and all the goodies… until one day, a bank failure hits and you lose all equity.
But in the age of TBTF, QE, and all these wonderful acronmys, (by the way, I believe these are not US or Europe specific, we have this here too, we just don’t call it as such), there is an implicit, or explicit put as well. The banks that live on grow to be even better capital generating machines. The question would be how to find those in hindsight.
Ultimately perhaps the call to invest in a bank becomes a more qualitative feel – mainly on how much can management be trusted.
Simply amazing post… forces the mind to think in many different scenario.
My query :- (Off topic)
* The same thinking can be taken further to have subsidiaries of a main( parent) company which might have debt like sword hanging on its own books and indirectly gets loaded up on the parents shoulders if incase something goes horribly wrong at the worst time. Also, Case of Financial Technologies Ltd and NSEL .
My query is this :- How do you calculate a return on such debt free parent company but which has a subsidiary involved into business which can backfire in case something goes extremely wrong . For example :- Parent Company A has subsidiary B which deals in Airline services and due to the crash of one of its plane… causes the liability to exceed exponentially even after adjusting the insurance coverage. I.e in such case it would be illogical for the parent company A to stepback from the whole episode and call off any fund infusion to cleanup the post crash litigation and other costs. Isn’t this case similar to a bank with leveraged balance sheet?? is it kind of negative black swan like a bank’s negative black swan??
(Another example could be a subsidiary which deals with Medicines (tylenol)
Thanks,
Vikas.G
Hi Prof Bakshi,
Just a small question. Given the fact that both financial and operating leverages have the same effect on the P&L, should we also make the adjustment when investing in companies with high operating leverages?
If yes, then how do we account for the fact that high operating leverages can also create economies of scale through fixed cost dilution and are hence a potential source of competitive advantage.
Looking forward to your reply.
Regards,
Fahd