The banking business is pretty simple in that a bank's profits are primarily a function of the difference between the rate at which it borrows and the rate at which it lends. However, the business of banking can be very complex. A bank can be viewed as a traditional hedge fund where the bank is long interest-earning assets (loans and securities, which have interest rate and credit risk) and short interest-bearing liabilities (deposits and borrowings, which have interest rate risk only) with a small strip of risk capital to absorb losses if and when they occur. Banking is all about leverage and with leverage comes risk and the bank's job is to manage that risk. I tell young people that if they really want to learn finance then they should work in the Treasury department of a bank because whereas in most industries finance is overhead, in banking finance runs the show.

One of the advantages of owning banks is that the bank's balance sheet consists of marketable assets (cash, securities and loans) such that tangible book value may act as a quasi-floor on market value given that credit risk has not gotten out of hand. In addition the bank will most likely be able to sell its deposit portfolio at a premium. Another advantage of owning banks is that they are regulated and as such are under intense scrutiny from Federal and State regulators. Many investors view bank regulation as a negative but I've always found comfort in the fact that Uncle Sam is looking after my investment because in many ways our interests are aligned.

One disadvantage of owning banks is that the bank's balance sheet can be very opaque in that an outsider does not know what risk time bombs are hiding in the shadows because the disclosures of such risks are more boilerplate than useful. Given that the strip of risk capital is small relative to assets (approximately 10% of assets) it doesn't take a lot of balance sheet problems to reduce capital to a point where the bank must raise additional risk capital (current investors are diluted) or is seized and liquidated (current investors are wiped out).

In today's interest rate environment banks are struggling. One of the main value drivers of a bank is the bank's ownership of non-interest bearing deposits (checking accounts, business accounts, etc.) and given the current low interest rate environment this funding source may actually have negative value because the cost to service these accounts may exceed the interest earned on these accounts. Pension funds and insurance companies are also struggling given that their returns are insufficient to cover expected future claims. I doubt that the central banks can keep interest rates at below market rates in perpetuity but if they can then the current business models for banks, pension funds and insurance companies may be untenable.

What I've found over the years is that banking as an investment is all about the business cycle and timing. At the top of the business cycle bank value is driven by bank earnings and return on equity. At the bottom of the business cycle bank value is all about credit risk. The business cycle is not like a sine wave where the distance from the trough to the peak (good times) is equal to the distance from the peak to the trough (bad times). Whereas the journey up the business cycle peak is long the journey down the business cycle is much shorter, which means that the investor does not have much time to both identify the cycle peak and make the necessary investment portfolio changes in preparation for the cycle trough.

This is what I've found to be true:

Late stages of recovery to the peak of the business cycle - Own banks based on earnings and return on equity. During this period credit losses are low and earnings are at their zenith. The general rule based on fundamentals (a term that may no longer apply in today's central bank-driven market) is that the higher the return on equity the more you can pay for the bank as a multiple of book value.

From the peak of the business cycle to the trough - Sell banks. During bad times credit risk is more important than earnings, and credit risk perception is more important than actual credit risk. During this period investor focus is on what could go wrong in the balance sheet. In a perfect world the bank's financial statements will show a reserve for losses that represents actual credit risk. Sadly this is not the case as loss recognition is protracted such that the investor is constantly waiting for the next shoe to drop (death by a thousand cuts).

From the bottom of the business cycle to the early stages of recovery - Buy banks based on book value rather than earnings. Many banks will have stock prices that are less than book value per share because investors over-estimate or can't get a handle on actual credit risk. If the bank survives and does not have to raise additional risk capital then the investor should do well if stock price recovers to a level where market value is at least equal to net asset value.

Notes: Many European banks are a mess and that situation won't end well. Deutsche Bank (Germany) is in real trouble (and has a $50 trillion derivatives book) and Greek and Italian banks may be insolvent sans a state-sponsored bailout. Small US community banks may be a good investment but these banks usually have low trading volumes so share marketability may be an issue (i.e. a high bid-ask spread).

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