Make a quick guess. How many banks in the U.S. have collapsed in the past 15 years since October 2000? 50? 100? 200? Given the stability of the local banks here in Singapore (there hasn’t been a bank failure here), the answer to the question above might be surprising (it was for me, at least), but some 539 banks have failed since October 2000, according to data from the U.S. banking regulator, the Federal Deposit Insurance Corporation. Source: FDIC The fragility of banks stem from their business model, which necessitates the need for leverage. A leverage ratio…
Make a quick guess. How many banks in the U.S. have collapsed in the past 15 years since October 2000? 50? 100? 200?
Given the stability of the local banks here in Singapore (there hasn’t been a bank failure here), the answer to the question above might be surprising (it was for me, at least), but some 539 banks have failed since October 2000, according to data from the U.S. banking regulator, the Federal Deposit Insurance Corporation.
The fragility of banks stem from their business model, which necessitates the need for leverage. A leverage ratio (total assets over total equity) of over 20 is often seen in the banking world; and when the use of borrowed money is mixed with the inherent volatility found in the economy, bank failures can become common.
This raises the question: Will the three big banks in Singapore – DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp Limited (SGX: O39), and United Overseas Bank Ltd (SGX: U11) – ever fall prey to the fragility that’s prevalent in banking?
It’s an important question to ponder given the banks’ outsized influence over both Singapore’s stock market (the banking trio collectively accounted for 32.3% of the Straits Times Index (SGX: ^STI), Singapore’s market barometer, as of 3 June 2015) and the economy (as examples, the three banks had a collective market share for deposits and loans in Singapore of 61% and 50%, respectively, in 2012).
Judging from history, there’s a reason to believe our local banks can endure the test of time: They have consistently displayed low efficiency ratios.
Source: S&P Capital IQ and banks’ filings
The efficiency ratio (the lower the number, the better), which measures a bank’s operating expenses as a percentage of its revenue, can be a good proxy for the amount of risk that a bank has to expose itself to in order to generate a decent profit from its banking business. My colleague John Maxfield explains further:
“Inefficient banks [with high efficiency ratios] appear to compensate for their inefficiency by taking on higher-yielding assets, which, not coincidentally, are also riskier. This allows them to generate profitability ratios in the short run that are comparable to their more efficient peers. But the downside to this approach is that, over the long run, it subjects the offending banks to potential failure when the credit cycle exacts its revenge.
Professor Charles Calomiris alludes to this in Fragile by Design: The Political Origins of Banking Crises & Scare 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.”
Furthermore, even if an inefficient bank wanted to maintain superior credit discipline, there’s reason to believe that it wouldn’t be able to do so. That’s because its more efficient rivals can afford to compete more aggressively on loan terms and screen potential borrowers more thoroughly. The net result is that less efficient banks are left fighting over a pool of less creditworthy customers.”
John’s view is given further weight when we examine how DBS, OCBC, and UOB had performed during the Great Financial Crisis of 2007-09, a truly horrifying time for banks in the Western world.
You can see a noticeable spike in the number of bank failures during the crisis period and its aftermath in the bank-failure chart above. In addition, there were many other huge banks which survived, but which had clocked horrific losses in that episode.
Singapore’s banking trio, meanwhile, were solidly profitable throughout the crisis years, although there was a slight dip in their profits during the period. These can be seen in the chart below:
Source: S&P Capital IQ
DBS, OCBC, and UOB may or may not be winning investments going forward (the valuation and future growth of the banks are key components in determining how well they might do as investments in the future; these are issues I’ve not discussed here), but at the very least, they’ve shown a strong history of keeping their operating costs in check, which in turn allows them to take on only moderate or low levels of risk and yet earn good profits.
This trait, if maintained by the banks’ management teams, puts them in good stead to survive (and perhaps even thrive against) the brutal test of time which has toppled a mighty number of Western banks.
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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 company mentioned.