Episode Transcript
The Finance Ghost: Welcome to episode 234 of Magic Markets and it's going to be, I think, a pretty cool show in which we're going to talk about how we look at banks. And the reason we are doing that is because last week we covered financials on the JSE, the week before that we had Dino Zuccollo from Westbrooke on the podcast. Go and listen to that if you're interested in what is essentially mezzanine financing, what they call hybrid capital in the UK space, and how these balance sheets are put together. And then this week in Magic Markets Premium, we've just finished recording our podcast and our report on Goldman Sachs, which is of course one of the most famous names in banking. Certainly one of the names that I thought, if all went really well in my career, maybe one day I would end up working there. But I ended up taking a very different route and I'm glad I did. But it's certainly a very famous name in banking. Moe, did you ever want to work at Goldman Sachs? Was that ever on your list?
Mohammed Nalla: Absolutely. I mean, which finance professional doesn't want to work at Goldman Sachs? Everyone had the dream.
The Finance Ghost: Exactly.
Mohammed Nalla: Go and work on Wall Street. And yeah, I guess for me it was like 9/11 happened and I was not going to go to New York. You know, as a Muslim guy, that wasn't going to turn out well for me. But you know, we kind of went down this route. I think we both ended up at an investment bank in South Africa, definitely not Goldman Sachs. We've had that part of our careers and again, it's given us fantastic insights, which is why a show like this is really quite welcome because we come with a - let's call it a very foundational knowledge of how banks work from the inside out.
And why this is so important is, again, some of our listeners have come back to us following the last couple of shows, and then obviously we're covering Goldman Sachs - and then they said, how do you actually look at banks, when you're analysing banks? And banks are banks, whether they operate in the US where they operate in South Africa, slightly different regulations, but when you're looking at the financials, you're generally looking at the same kind of metrics, the same subset of numbers. And so we thought that a foundational understanding of how you analyse banks would certainly be quite welcome.
So Ghost with that as the backdrop, I'm going to first jump in and say that when you're looking at banks, a couple of things to understand is when you're looking at the balance sheet - because that's what you're looking at when you start off with a bank, I start off with a balance sheet, right - is that you've got assets and liabilities. But with a bank, it's the other way around compared to an ordinary company, because the bank would look at its liabilities as the deposits that people effectively leaving their money at the bank would have. The bank sees those as liabilities because they owe you that money at the end of the day. And then on the asset side of their balance sheet are the loans that they've given out to people - the mortgage for your house or your car or your credit card, that's the bank's assets. So it's very important to understand that when you're looking at the bank, you're generally looking at it the other way around, where the liabilities are the deposits that people have left with them. The assets are the loans that they've actually given out to the market. And I think that's a very good starting point for people to just understand, because then that actually flows through to looking at metrics like: what is the loan to deposit ratio, for example? How many deposits do we have on the book versus how many loans we've got out there? And that's important as a measure of liquidity or just how well the bank is doing at letting some of that capital out and earning a return on it.
And then another one linked to that would be something like the net interest margin, because they put the loans out there, but they've got to earn a return on that. And that's an interesting one because it's not just how much they're charging for the loans, but you've also got to bring into that how many bad debts are there, how many of those loans don't get repaid. All of that eventually rolls up into what is the net interest margin.
So I'm going to pause there Ghost, because I'm sure you've got a lot to add at the headline level and then we can actually drill this down into specific items either on the income statement or on the balance sheet.
The Finance Ghost: Yeah, before I even get into that, I mean what's really interesting is the comments you made about 9/11. I'd obviously never thought of it through quite that lens – that it probably wouldn't have been a great time for you to go to New York. I can understand that.
What it did remind me of though is that you were in banking in the glory years, the pre-2008 - I'd forgotten that too. And it's amazing that bull market - it's incredible how much banking changed after the Global Financial Crisis and it, it has never been exactly the same since. I mean there was a time when banks were allowed to do very different things with their balance sheet, right. to what they are allowed….
Mohammed Nalla: Yeah, I want to add in because there were certainly glory days, Ghost. I mean just waxing lyrical a little bit - but we've just covered Goldman Sachs and again if you're not a Premium subscriber, go and check that out, it's only R99 a month for great, deep insights there from the bottom up - but the point that kind of came out was the compensation ratio. And in those glory years of investment banking, I'll just throw one anecdote out there. There was a specific team at the bank that I was working at. They were very successful, a trading desk and for their team-build the entire team was flown to Dubai and went on like a little team building in Dubai, went skydiving and then came back. Now I unfortunately was not part of that desk. I just joined the dealing room floor and my eyes were this wide open - but those were the glory days and I caught the very tail end of that. And then unfortunately things changed, regulation changed and I would say for myself as well, compensation changed. Those trips overseas and the big bonuses, those got watered down a little bit. But I still think it's a very lucrative space and again we can get into some of that, but interesting anecdote if you like that.
The Finance Ghost: It's true, I remember some of the time that I was in banking, it was more like a team got pizzas on a Friday and people were like ooh, that's quite extravagant. So yeah, I didn't know that wonderful bull market and the point I was going to make was you started this talking quite correctly about assets and liabilities and how it's actually effectively the other way around to what you would normally understand it as. And what's changed so much in banking since the global financial crisis is the risk weightings and the way those balance sheet calculations are done. It's a highly, highly regulated space, it really is. Your liability is the bank's asset and the way the bank puts a risk weighting on that asset is very, very important. And the amount of capital they need to hold on their balance sheet because of those assets is then very important.
And there are different rules depending where you look in the world, if it's a Basel thing – and in the US they seem to march to their own tune really. And to be quite honest, half the time the banking execs don't even know what the answer is going to be when all those calculations are run. I mean there was a very funny comment in the Goldman Sachs transcript that we just dealt with where it was either the CEO or the CFO, it hardly matters, basically he said, I think the exact quote was “and we were very confused when our risk weighted assets calculation came back last quarter” - so it's basically like they submit all their numbers and then the regulator says, oh you know, here's, here's how much equity you need to hold for this thing. And they find out where they're at and then they have a buffer for it.
Obviously the more equity you need to hold against specific assets, the more onerous that is for your balance sheet, the lower your return on equity. And so that's why whenever you're looking at banks, the metric that comes up over and over and over again, and this is true whether you are looking in the US or you are looking in South Africa, is return on equity.
And what's particularly interesting is if you look at South African banks, return on equity is generally speaking in the teens and it kind of goes from low- to mid-teens for some of the less successful banks, then sometimes FirstRand will stick their nose above 20%. I'm not sure what their latest number is now, but you will see numbers like that. What's interesting in the US where obviously now this is a dollar-based economy, there's a huge differential in the risk rate between South Africa and the US so you would expect to see much lower, structurally lower return on equity. And yet that's not really what happens. The likes of JP Morgan reporting return on equity that in percentage terms, before you make any adjustments for the fact that one is hard currency and one is South Africa, ends up coming out at roughly the same as some of our very good banks.
This is why US banking is just such a lucrative place to have been invested. I have JPMorgan and Goldman Sachs in my portfolio. I've held them for a long time. And I'm very glad that I have, because it really is just a play on the US economy. And I think that's an important point about banks. There are rare examples where you can escape the systemic story. And we talked literally last week on this podcast about financials on the JSE and how it's so nuanced because obviously SA macro is not that straightforward. You can go and buy something like Capitec and you can get this amazing growth story, they win lots of market share. But generally speaking, you're buying a macro story. And in some way, like the US, you do end up with that “rising tide that lifts all boats” situation on Wall Street, for example. Yes - you're going to have - it feels like you have winners and then like big winners, as opposed to winners and losers once you go outside of the US and that's a big part of the appeal, I think, for me and why I'll hold things like Goldman Sachs and JPMorgan, both of which have done very well. Although you've also pointed out some names in financial services that have either beaten them or come close that are not banks. So there are many ways to make money in this market.
Mohammed Nalla: Indeed, I'm not going to share those names on this podcast because that would be a disservice to our Premium subscribers. I do share some of those names on the podcast we've just done on Goldman Sachs. But you've actually raised something interesting for me, Ghost, is that coming from a banking background, when I look at a new market geographically, I've just realised now that I almost default to looking at the banks first because I understand banks. They're largely similar across geographies. It's the same business model. They're easy to compare if you're just comparing metrics across the financial statements and so forth. And I'm actually invested in a couple of the US names, but I'm also invested in a couple of the Canadian banks. And one of the reasons for that, is that Canadian banking is somewhat similar to South African banking in that it's very oligopolistic. I guess it's not too dissimilar in the US, you've got a long tail of small regional and community banks in the US but when you're looking at the larger banks, it's just a handful of names. And in Canada it's very much the same thing. You're investing in maybe the top four or five banks in Canada, they pay out decent dividends and it becomes a macro story to a degree. But then on a relative basis, when you're choosing one bank over another, that's where the analysis does tend to make quite a bit of a difference.
Now I'm going to touch on a point you raised around return on equity because I started out saying you've got to look at the balance sheet. Banks are traditionally very highly levered compared to a conventional business. If you are comparing a bank to let's say something in industrials, they're completely different animals because the bank's entire business centres around leverage. And so I would caution around a direct comparison on what ROE is in this sector versus other sectors. Where the use case comes about for me is comparing within the banking sector. I think that's very useful. And then another useful metric that I tend to use a lot when we look at banks, and it does apply in some instances, but not in all instances, would be what are you paying - so price-to-book ratio effectively - for that return on equity.
And that's where it's quite interesting again just to see historically how has the firm's own relative ROE to price-to-book ratio gone over time? Are you paying more for every return on equity that you would be getting from this bank versus some of their peers? Now that's important because you can't really use a price-to-book ratio that well on some other firms or some other sectors. But that in my view it is quite relevant when you're looking at the banking sector. I'm going to pause there again, Ghost, because my next point I'm going to start talking about the risks. I want to start talking about credit risk, non-performing loans, but let's see if you've got something to add on here on the balance sheet side of things before we actually move on to some of the risk metrics.
The Finance Ghost: I think let's get to the non-performing loans. That's really where the rubber hits the road, right? That's actually what links the income statement and the balance sheet. That's essentially where it says, okay, here's what's on the balance sheet, what does this really look like now from an income statement perspective? That credit loss ratio is key.
Mohammed Nalla: Yeah, absolutely. I mean, I'm quite a risk averse individual. And so when you're looking at banks, because the banks putting out loans, they're looking at something like a non-performing loan ratio or what provisions is the bank making against non-performing loans? That tells you a couple of things because as you correctly say, it links the balance sheet, the loans that are out there, to the income statement. You're going to get some sort of interest-linked return on the loans that you've put out. But some of those loans are going to go bad, not everyone's going to repay them. Some of them are going to be deferred or restructured. And so effectively, the bank's got to either provide for those loans saying, okay, we’re looking at the risk on the book, we think it's deteriorating because maybe the economy is deteriorating. And so in order to kind of smooth that over for their longer-term investments, they make provisions against those and that comes through in terms of what they call your loan loss provisions. I think in South Africa it's called the same thing. And that shows you how conservative a bank is being relative to the risk that they have on the book.
Now, if you actually see that they're making larger provisions, this means they're being a lot more cautious. So it also filters through in terms of what can we look forward to in terms of the bank's own operations of extending new loans. Because it stands to reason that if the loan quality, the credit quality is deteriorating on a macro level, they're probably not going to want to go and write a whole bunch of new loans out there. So that's telling you what to expect on the long run, almost forward guidance, the macro outlook.
Linked to that - that's a provision, that's a cautionary kind of tale - on the other side of that are actual loans that have gone bad and those are non-performing loans. And that is a ratio that they would look at. I know in the US, traditionally they say 90-days plus overdue as a percentage of overall loans or total loans. And that's telling you, yes, maybe the bank's really cautious, but actually is it deteriorating as much? This is where the rubber hits the road. Because if the bank's underwriting was poor, then you're going to actually see the NPL ratio tick up. And that's a bank doing its job badly. On the flip side, the bank could be very cautious, but if the NPL ratio is actually falling, it means that that caution is just a bit of a buffer, but that the bank's underwriting policies are still sound. That's the way I look at it. And again Ghost, we can tie that into how that links to the capital adequacy ratios and how much capital the bank actually holds on the balance sheet. But again, I'll pause there. I'd like to hear your thoughts on the NPLs as well as those provisions as well.
The Finance Ghost: So the one thing that I'll highlight there is certainly when you read the South African bank reports, what you'll typically see is this concept of a through-the-cycle credit loss ratio, which is basically - the credit loss is essentially the movement in that provision, right? So this is a really important point because you can actually see some very big moves in banking earnings based on a significant shift in the credit loss ratio. So even if the underlying business has kind of had a pretty average year, expenses have done their thing, if you have a big improvement in that ratio - and we saw it recently at some of the local banks, I think it was ABSA that had a significant improvement in or through-the-cycle credit loss ratio - and what that does is it basically gives you this once-off nice uptick in your earnings. And then once you get into that range, now that's where you are - you're not going to see another big step change. And as things really deteriorate, it's unlikely that they dip below their through-the-cycle target because that actually means they're not taking enough risk. So it is also a balance, they can't be saying, well, there's going to be no credit risk on the book because a bank that doesn't take credit risk is a bank that doesn't have a business. They have to take credit risk. That's the whole point. But it's about balancing that credit risk against what they can price it at.
And there's also a lot of stuff that happens behind the scenes in that balance sheet management environment around the mix of loans. How much of it is home loans, how much of it is card, how much of it is personal loans, how much is corporate, SMEs, property? It gets quite granular. They'll do - obviously your large clients will come up as a major risk flag and that'll be managed on a balance-by-balance basis at corporate level. And that's why a lot of these restructurings and a lot of the way the banks work now, they all have this CIB division where all the biggest clients are in one place, so they can actually understand what their exposure looks like. They'll have their retail banking on the other end. And it's very interesting to see how those exposures are all managed.
And it's also why you have stuff like home loan originators, because you'll have times where a specific bank actually doesn't really want to be putting more mortgages out. And so they'll price them in a way where if they get one, great, but you know, if the client says no, that's also okay. And so this is why your mortgage originators go to all the banks and say, okay, here's the client, who wants to lend to them? Often people will move bank when they are looking for mortgages and they take it very personally and they get very angry and they go and shout on social media. The bank doesn't actually care about who you are, your bank cares about managing their portfolio. And if you ask them for a mortgage at the right time, you will get a great price. And if you ask them at the wrong time when they're worried about credit or they are over indexed on mortgages, you'll probably get a bad price.
Mohammed Nalla: I think that's such an important point because you've got to consider that the bank's looking at this in terms of: are we over-exposed to a particular product class? They also look at the vintages or the buckets - we've got a lot of loans out in maybe the 10-year bucket, we've got some maturing in the 5-year bucket and so forth. And this becomes important as we link this into capital adequacy and liquidity metrics. Because at the end of the day, a bank is around that liquidity mismatch - that's really what you've got to look for at a bank is because they're taking in deposits, those are short term in nature. You can go to your bank, you can withdraw your money pretty much on demand for most transactional or even savings accounts. But at the same time, that bank has given someone a loan that's going to be repaid over 10, 20, 30 years, even up here in North America. So if you get what is called a run on the bank, if there's a crisis and people go and make massive withdrawals of their deposits, this leaves the bank with a massive liquidity mismatch. In order to ensure that they stay in business, they stay a going concern, they've got to meet certain thresholds in terms of just how much equity they have, how much tier one capital they have.
That's where those regulatory, let's call it guardrails come in. Because we've seen the Global Financial Crisis, regulators don't want to see that happen again. They want the systemic risk to be managed. And so if you look at the US, most of their banks, if we're looking at the larger banks, are supremely well capitalised. They are well through their regulatory limits. But when you're looking at the smaller banks, the community banks, some of those have hit the wall quite recently, like within the last year. I think - I can't recall the name of the bank, but there was a small community bank that hit the wall and effectively JPMorgan stepped in, bought them out and brought that risk onto their book because they had the surplus capital and they figured they were getting it at a decent price.
Now these are all very important. Remember I mentioned the loan to deposit ratio. There's a liquidity coverage ratio that comes through as well. And these are all risk metrics to tell you how close to the wind the bank is actually sailing.
Now, Ghost, you've raised one last very important point that I'm going to touch on and then I'll stop here. And that is there's a lot happening behind the scenes, not just in the balance sheet management space, but overall capital allocation space. Because if the bank is sitting with surplus capital versus what they’re required to hold by regulation, what do they do with that capital? Do they go out there and make a whole lot more loans or do they return some of that to shareholders through dividends, through share buybacks? And that's where it gets quite interesting, because if you look at dividend payout ratios at some of the banks in the US, those have been rising. But again, in South Africa, your yields on your banks are actually quite decent. They're pretty decent up here in Canada. If you're looking at some of the US banks, those yields are still fairly low versus the type of payout ratios that you're seeing in other jurisdictions. And so I look at that because that's a very important metric as an investor.
Yes, I love a good dividend, but at the same time I want to make sure that, that the dividend payout ratio that stands behind that is not overly stretched because that starts to become a risk to the sustainability of the dividend over the longer term as well as to the bank's underlying balance sheet health and the ability to stay a going concern, should we see some sort of market friction or market fracture.
The Finance Ghost: Yeah, I always joke that there's a very big difference between a going concern and an ongoing concern. And if you've ever seen the risk weightings of these things and the way that people think about credit losses, then that does come to the fore, without a doubt.
I mean, banking is such a gigantic topic. We literally haven't even scratched the surface at all around any of the concepts like non-interest revenue and how all of this lands on the balance sheet in terms of boosting return on equity because NIR is generally earned off capital-light businesses, which is something that came through strongly in the Goldman Sachs show that we just did.
I think we'll probably have to leave it there for this week in terms of having dealt with some of the really interesting concepts around risk and how capital needs to get held on the balance sheet, how that turns into non-performing loans and credit loss ratios, and managing this overall story to our listeners. If banking really interests you, then you will love our show on Goldman Sachs. I think you'll learn a lot from what's in there and the different ways in which they make money because Goldman Sachs is definitely not a traditional banking business at all, which is part of what makes them so interesting. So if you aren't already a Premium subscriber, then do consider joining us there. And if you are a Premium subscriber, then head on over to the Goldman Sachs show and report if you haven't checked it out yet because you will enjoy it. And if you go and search in the library, you'll find JPMorgan in there as well. Loads and loads to learn.
Moe, we'll leave it there and to our listeners also, if you've got ideas for stuff you want us to cover, then send it through. We obviously love responding to requests for topics that we can dig into on the show.
Mohammed Nalla: Indeed. Ghost, it's been fun. If you're a listener, you know, send us those requests. We'll either look at covering that in Magic Markets Premium or on the free show. Hit us up on social media. It's @MagicMarketsPod, @FinanceGhost and @MohammedNalla all on X or go and find us on LinkedIn. Pop us a note on there. We hope you've enjoyed the show. Until next week, same time, same place. Thanks and cheers. Ciao.
This podcast is for informational purposes only and is not financial or investment advice. Please speak to your personal financial advisor.
