Understanding the Financial Health of a Bank
The last 9 months have been difficult for the banking and finance industry and more stumbling blocks lurk ahead. Geoff Greenwade outlines some of the pitfalls and the tools that depositors can use to understand the financial position of their bank. His recent submission to the Houston Business Journal talks about the common cap rates provided by the FDIC and how to decipher them.
As published in the Houston Business Journal’s
Banking & Finance Quarterly—August 1, 2008
Quick evaluation tools for a rapidly changing market
By Geoff Greenwade
There hasn’t been much good news about banks for the last nine months and the recent concerns of Fannie Mae and Freddie Mac have many consumers wondering if their institution will soon be in the headlines. Banks that did not dive head-first into the subprime mortgage market might have missed a big pitfall, but are moving cautiously. Delayed write-offs and the slowing economy are still at work and can quickly change things, especially for banks and depositors who are not following the market. Issues that many in the industry are tracking include:
• Lower lending capital - Recent write-offs have reduced the capital that banks have to lend. Less lending means less profit and loans are more difficult for consumers and businesses to secure.
• Unresolved balance sheet uncertainty - Banks holding mortgage-related assets are having a difficult time assessing their current worth. These assets are sitting on the books with questionable value and will probably fall in the coming months.
• Consumer loans – Although the media focus is on mortgages, delinquencies on credit cards, auto loans and unsecured personal loans are on the rise.
• Commercial loans – Not as prevalent in Houston or other Texas markets, commercial lending, once heavily fueled by real estate, has slowed and the largest banks are likely to see earnings dip; nation-wide banks will probably feel a greater sting.
• Investing in default insurance - Credit default swaps are basically insurance policies against default. In recent years, many banks invested in these because of an all-time low in default rates. Now these policies might be called to cover losses.
Smart investors realize that a bank, like any new investment opportunity, must be researched and understood before opening an account. Just ask IndyMac investors about the costs of making assumptions on the size of a bank or Bear Stearns investors who relied on reputation only—more investors are now looking beyond marketing pieces.
The easiest thing to do is to ask your banker about the assets of the bank, collateralized debt obligations, subprime mortgage loans and other high-risk assets. If you are thinking about striking a new relationship or like to do your own research, the Federal Deposit Insurance Corporation (FDIC) offers numerous tools to understand the health of a bank, its loan portfolio and potential risks. Their Web site, www.FDIC.gov, also has an Electronic Deposit Insurance Estimator that determines the level of FDIC-backed deposit insurance coverage for multiple accounts at one institution.
Banks are required to maintain a certain level of reserve capital in relation to assets. The regulatory minimums standards of “well capitalized banks” change according to different evaluation ratios. Generally, a larger cushion provides better protection to depositors as it allows the bank to absorb occasional losses.
Regulators and bankers use three primary ratios to determine how much capital cushion exists:
The Tier One Leverage Ratio is the most common evaluator and it measures the total investment by shareholders, including certain other investments that count as capital, reduced by goodwill and other intangible assets against the average total assets of the bank for a particular quarter. The minimum ratio to be considered “well capitalized” by regulatory standards is five percent.
Next, the Tier One Risk Based Capital Ratio rates the same capital amounts but compares to assets that are weighted by risk. Riskier assets, like loans, are weighted at 100 percent, while safer investments, like government bonds, are weighted at 50, 20 or zero percent. Naturally, the risk based capital standards are higher–the minimum ratio for “well capitalized” banks is six percent.
Finally, the Total Risk Based Capital Ratio takes into account the capital a bank has set aside in reserves for loan losses. This ratio compares that capital amount to the risk weighted assets described above. The minimum ratio to be considered “well capitalized” by regulatory standards jumps to ten percent.
These ratios are public information and available on the FDIC Web site through mandated quarterly reports that are submitted by every bank. Found under Call Report and Thrift Report (TFR) Data, Schedule RC-R lists these ratios. The volume of data is tremendous, but basic research, even if it is just these ratios, helps investors better understand the financial health of a bank and ask the right questions when meeting with its officers.
In the end, the most successful investors treat all investments the same. They take the time to understand the asset allocation of an investment and its entire risk profile. The FDIC provides tools for understanding the real numbers behind a bank.
Geoff Greenwade is the president and chief executive officer of Houston-based Green Bank. Conceived by banking veteran Manny Mehos, the founder of Coastal bank, this new banking model works to reduce operating resources, create less waste and reward customers who chose environmentally-friendly service options for their accounts.