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Two Metrics Bank Investors Must Know

There are three banks among the 30 constituents of Singapore’s stock market barometer, the Straits Times Index  (SGX: ^STI). These banks are DBS Group Holdings (SGX: D05), Oversea-Chinese Banking Corporation (SGX: O39), and United Overseas Bank (SGX: U11).

The banking trio all have large market capitalisations, and thus collectively accounts for almost a third of the movement of the market cap-weighted Straits Times Index.

Bank

Market Capitalisation
( as of 24 Dec 2013)

Weighting within Straits Times Index(as of 24 Dec 2013)

DBS

S$41.17b

11.07%

OCBC

S$34.74b

10.38%

UOB

S$32.92b

9.26%

Source: S&P Capital IQ; Data for SPDR Straits Times Index ETF.

What this means is investors can be unwittingly exposed to a large degree to these banks by virtue of their sheer size. That’s especially true for investors in index-trackers like the SPDR Straits Times Index ETF (SGX: ES3), which as its name suggests, tries to mirror the Straits Times Index’s movement.

Because of that, it might be worthwhile for investors to gain a better understanding of the banks. We’ve previously run through two important metrics that applies to banks, namely the Price to Tangible Book Value, and the Return on Asset.

Today, we’ll be taking a look at the Net Interest Margin, and the Non-Performing Loans/Total Loans ratio.

1. Net Interest Margin

One of the key ways that banks earn their keep is to collect interest from the loans they make. But, at the same time, banks also have to pay interest on the sources of their funds, which generally come from depositors’ money.

The net interest margin is thus the spread between the interest a bank charges on the money it lends out, and the interest that a bank pays on the deposits it receives.

This spread is affected by a number of factors, which includes the overall interest rate environment; the economic health of Singapore and the world; the amount of competition a bank faces from its peers in making loans; and the level of risk a bank is taking on with its loans (in general, the riskier a loan is, the higher the interest a bank charges), among others.

Investors would certainly prefer for a bank to charge the highest amount of interest on the loans it makes, while doling out the lowest possible interest on the deposits that it collects. But, that’s easier said than done.

Ultimately, money is a commodity and it’s not hard at all to imagine how borrowers would almost always choose loans from banks that offer the lowest possible interest. That makes it hard for a bank to charge high interest and earn a large Net Interest Margin.

Here’s how the Net Interest Margin for DBS, Oversea-Chinese Banking Corporation, and United Overseas Bank looks like:

bank net interest margin

Source: S&P Capital IQ

As we can see, the banks have been seeing declining net interest margins for a number of years. This makes growth in loan volumes the only possible avenue for the trio to grow their interest income. Thus, there’s the possibility that the banks might lower the quality of their loan portfolios by accepting lower returns for higher risks in a bid to drive growth.

This brings us to the next important metric that investors have to know about a bank.

2. Non-performing Loans/Total Loans ratio

The quality of loans that a bank makes is quite possibly the most important thing in determining its success as a corporate entity. And though it’s close to impossible for a bank to be paid back for every loan that it makes, a well-run bank would be able to keep delinquent loans to a minimum.

For a quick check-up on the quality of loans a bank makes, investors can turn to the non-performing loans/total loans ratio. As its name suggests, it measures the percentage of bad loans that a bank has amongst its entire portfolio of loans.

One important thing to note about the ratio is that it can give investors a glimpse into the future for any potential trouble to come, especially if it is climbing.

This is how the three local banking stalwarts’ loan quality has evolved over the years:

bank non performing loan to total loans

Source: S&P Capital IQ

We can see that OCBC and UOB have improved their loan portfolios by quite a fair bit since 2005, while DBS has maintained the level of its loan quality. And judging from the current non-performing loans/total loans ratio for the three banks, it would seem that OCBC would have the least trouble with its loan portfolio in the future.

Foolish Bottom Line

Banks are notoriously complex entities to analyse. My colleague David Kuo even once called them (and rightly so) “mysterious black boxes…[where] money goes in one end and (hopefully) money comes out the other.”

While simple metrics such as price to tangible book value, return on assets, net interest margin, and the non-performing loans/total loans ratio can help investors with their analysis of banks, it’s by no means the end. In fact, it’s just the beginning.

Many other factors come into play. We have to look at how well a bank has performed over time; the presence or absence of growth opportunities it can easily capture; the quality of its management team; and its prudence or recklessness when it comes to managing risks, among others.

That’s something investors should bear in mind when it comes to looking at banks for investing opportunities.

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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 writer Chong Ser Jing doesn’t own shares in any companies mentioned.