Here’s How You Can Tell If Your Bank Shares Are in Any Danger

Banks make up a large portion of Singapore’s share market. For instance, the three local banks, DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp. Limited (SGX: O39), and United Overseas Bank Ltd (SGX: U11), collectively account for 33% of the SPDR STI ETF (SGX: ES3) as of 6 November 2014. The SPDR STI ETF is an exchange-traded fund which aims to replicate the fundamentals of Singapore’s market benchmark, the Straits Times Index (SGX: ^STI).

So, if only for the reason that the banks have such a strong presence in our local market, it would be interesting to think of telling signs which can point towards deterioration in the business-performance of a bank.

On that note, my colleague in the U.S., John Maxfield, has a simple but useful way to look at the issue and it has to do with the efficiency ratio of a bank. The ratio measures the percentage of a bank’s revenue that goes into non-interest costs (the lower the efficiency ratio, the better) and can be used as a good gauge of a bank’s cost discipline.

Interestingly, the efficiency ratio can also be used as a proxy for the amount of risks that a bank is forced to take in order to earn a decent profit. This is how John describes it:

[T]ere’s a strong correlation between a bank’s efficiency ratio and its nonperforming loan ratio. Namely, banks with higher efficiency ratios have a tendency to write worse loans.

Efficiency ratio and loan losses for American banks

I noted at the time that this correlation seems to follow from the fact that a bank’s objective is to maximize return on equity. If this objective is hindered by low efficiency, then the slack must be made up through other means. And the easiest way to do so is to write higher yielding, and thus riskier, loans.

Columbia business school professor Charles Calomiris touched on this point in his bookFragile by Design: The Political Origins of Banking Crises & Scarce Credit: “Given an environment in which risk-taking with borrowed money was considered normal, it is easy to understand why some bankers, particularly those who were having trouble competing against more efficient rivals, decided that the right strategy was to throw caution to the wind.”

From John’s work, we can see how changes in a bank’s efficiency ratio can be a canary in a coal mine in detecting whether a bank has to start engaging in potentially dangerous activities like writing riskier loans.

Over the past decade, the local banking trio of DBS, OCBC, and UOB have had remarkable cost discipline, as seen in the chart below, with their low efficiency ratios. That prudence had likely also resulted in the three banks surviving tthe Great Financial Crisis of 2007-09 admirably.

Efficiency ratios for DBS, OCBC, UOB

Source: S&P Capital IQ; Banks’ earnings releases

For the first nine months of 2014, DBS, OCBC, and UOB clocked very healthy efficiency ratios of 44%, 39.5%, and 41.8%, respectively. These figures have also not deviated in any significant manner at all from their past trends. From this, investors can rest easy with the banks – there’s no imminent danger.

But that said, if the efficiency ratio for the banks ever starts moving up significantly in the future, investors might want to sit up and take notice, and start digging into the phenomenon.

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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.