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Are Banks Safer Now?

Danger sign It’s been more than five years since the Great Financial Crisis of 2007-2009 occurred. During that period, big American banking giants with illustrious histories like Lehman Brothers and Wachovia went bankrupt, while luckier ones like Bear Stearns and Merril Lynch were rescued by their banking-brethren.

Many other big Western banking behemoths; like Citigroup (NYSE: C) and Bank of America in USA; and Royal Bank of Scotland in the UK, to name but a few, ran into grave trouble.

And after all was said and done, it was clear that the deeply troubled banks – as well as those that went under – had to shoulder most of the blame for the crisis due to their cavalier attitudes toward risk and taking on enormous leverage.

With leverage causing so much turmoil in the financial markets and subsequently in economies around the world, it would make sense for us to want to know if banks have been more prudent now with using borrowed money to boost profits.

While it’s a complete understatement to say that the financials of banks are tough to understand, there are quick-and-dirty ways to gauge how much leverage a bank is taking on. One such way would be to look at a bank’s Tangible Book Value (TBV) as a percentage of its Total Assets (TA).

In general, the lower the percentage, the more highly levered a bank is. And consequently, the more risk it’s taking.

A simple formula for TBV is given as:

TBV = Total Equity – Minority Interests – Goodwill & Intangibles – Preferred Equity

Wells Fargo, a Warren Buffett favourite, was one of the American banks that escaped relatively unscathed in the crisis. The bank earned a profit of US$2.66b in 2008, when the crisis was at its peak. And, even though the amount was a 67% decline from the previous year’s earnings, it was still a heroic effort when compared with the US$27.7b loss that Citigroup suffered in 2008.

So, given their hugely contrasting fates when the crisis was in full swing, it would be instructive to see how these two American banks’ leverage levels had differed in its build-up.

Banks safer chart 1

The chart above shows how, prior to the crisis, Citigroup had increased its leverage from more than 4% at the end of 2005 to only 2.7% at the end of 2007. To put things into perspective, at a 2.7% ratio for TBV-to-TA, Citigroup was essentially borrowing $37 for every $1 it had in tangible assets – tell me that that’s not reckless borrowing!

On the other hand, Wells Fargo was much more prudent with its leverage, saving itself from a lot of trouble in the process, as its ratio of TBV-to-TA was much higher than Citigroup’s prior to 2008.

Interestingly, the leverage that both banks have utilised since the crisis have dramatically decreased – with the Basel III requirements on Capital Adequacy Ratios (which limits the use of leverage) as a likely reason for the phenomenon – suggesting that they are perhaps taking on lesser risk as compared to just a half-decade ago.

Looking at the US banks, it naturally brings us, Singaporeans, to wonder how the balance sheet of our local banks have changed in the crisis-episode.

The three local banks, DBS (SGX: D05), United Oveerseas Bank (SGX: U11) and Overseas-Chinese Banking Corporation (SGX: O39), had acquitted themselves admirably during the crisis. And looking at the chart below, it was not hard to see why – the local banks were basically employing significantly smaller leverage, as compared to the likes of Citigroup, before the crisis.

banks safer chart 2

Given the importance that DBS, UOB, and OCBC have on Singapore’s stock market due to their heavy weightings in the market-cap-weighted Straits Times Index (SGX: ^STI), it would also make sense for investors to know where the banks stand at the moment in terms of leverage.

On that front, it’s perhaps a good sign to see that the leverage on the local banks’ balance sheets have not changed much, suggesting prudent capital management.

Foolish Bottom Line

Banks, when they’re run properly, are an indispensable part of the modern economy. They help fund investments and provide crucial loans to individuals and businesses alike. But, when risk-controls go amok and leverage rules the day, all hell breaks loose, as it has happened so regularly in history.

That’s perhaps why having a simple rule of thumb to gauge the levels of risk that a bank is taking with its balance sheet is so crucial for investors who are trying to spot for signs of trouble.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.