I had recently visited the Australian Outback. When I was not admiring the majesty of ancient rock formations such as Uluru and Kata Tjuta, I was poring over Mervyn King’s book, The End of Alchemy: Banking, the Global Economy and the Future of Money. King has a long and distinguished career in the world of finance and served as the governor of the United Kingdom’s central bank, the Bank of England, from 2003 to 2013. His book delved deep into monetary policy and his ideas on reforms that central banks around the world should undertake. But as an investor…
I had recently visited the Australian Outback. When I was not admiring the majesty of ancient rock formations such as Uluru and Kata Tjuta, I was poring over Mervyn King’s book, The End of Alchemy: Banking, the Global Economy and the Future of Money.
King has a long and distinguished career in the world of finance and served as the governor of the United Kingdom’s central bank, the Bank of England, from 2003 to 2013. His book delved deep into monetary policy and his ideas on reforms that central banks around the world should undertake.
But as an investor in Singapore, what caught my eye in the book is King’s discussion on how financial risk can be measured in banks.
The three local banks we have in Singapore’s stock market, namely, DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp Limited (SGX: O39), and United Overseas Bank Ltd (SGX: U11), are some of the largest listed companies here. They are also where many Singaporeans deposit money in and where many companies in Singapore obtain financing from.
In my view, these traits make it important for investors to have a good handle on the financial risks that the trio of DBS, OCBC, and UOB are sitting on.
One way investors can gauge the level of financial risk a bank is taking on is by looking at the amount of equity capital a bank has as a percentage of its risk-weighted assets. An example of such a risk-weighted measure is the Common Equity Tier 1 Capital Adequacy Ratio (CET1 CAR).
The latest requirement by the Monetary Authority of Singapore is for banks here to have a CET1 CAR of at least 6.5%. DBS, OCBC, and UOB are all way above that hurdle – as of 30 June 2016, they have CET1 CARs of 14.2%, 14.9%, and 13.1%, respectively.
But, it’s worth noting that such risk-weighted ratios may not give the best picture of the real financial risks a bank is saddled with. King explains in his book:
“It is extremely difficult, if not impossible, to judge how the riskiness of different assets will change in the future. The appropriate risk weights can change abruptly and suddenly, especially in a crisis.”
What King thought was a better way is to look at the far simpler leverage ratio – the ratio of a bank’s total assets to its equity. The usefulness of the leverage ratio over risk-weighted ratios of capital adequacy is illustrated by King with the example of Northern Rock, a British bank which failed in 2007 (emphases mine):
“At the start of , Northern Rock had the highest ratio of capital to risk-weighted assets of any major bank in Britain, so much so that it was proposing to return capital to its shareholders because they had no need of it – under the regulations. At the same time, the bank’s leverage ratio was extraordinarily high at between 60 to 1 and 80 to 1.”
With a leverage ratio of 60 to 1, a mere 1.7% (!!) decline in a bank’s assets would be enough to kill it. At 80 to 1, an incredibly tiny downward fluctuation of 1.25% (!!!) in a bank’s assets would sound the death knell.
Thankfully for investors in Singapore, our local bank trio of DBS, OCBC, and UOB – and this is what pleases me – currently have low leverage ratios of 11, 11, and 10, respectively (these leverage ratios are the ratio of total assets to shareholder’s equity). And as you can see in the table below, DBS, OCBC, and UOB’s leverage ratios have also not increased by much – if at all – since at least 2007.
Source: S&P Global Market Intelligence
So, investors can rest easy now knowing that the three banks are currently not sitting on any highly dangerous financial risks. But, the matter of whether DBS, OCBC, and UOB are good investments at the moment is another story.
For more investing insights and updates on what's happening in the world of finance, you can sign up here for a FREE subscription to The Motley Fool's weekly investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.
Also, like us on Facebook to follow our latest hot articles. The Motley Fool's purpose is to help the world invest, better.
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 does not own shares in any companies mentioned.