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Investors Should Look At These 2 Metrics For Bank Stocks

Finding good companies to invest in can often be a challenge. This challenge is amplified due to subtle differences which must be considered by investors for different sectors. For banking stocks, it is especially different. In this article, I will look at two banking-specific metrics which investors should use to make informed choices when evaluating bank stocks.

The loan-to-deposits ratio

The loan-to-deposits ratio (LDR) is a critical ratio for investors to note. But to understand why, we first need to get a handle on the business of banking.

A bank is essentially in the business of loaning money. A bank collects money in the form of deposits and uses it as capital to loan out to individuals or companies. The bank makes money by charging interest on the money that it loans out and paying a lesser amount of interest to depositors.

Now that we have a summary of how a bank functions, let’s return to the LDR. The ratio tells us how much risk a bank is taking. Every loan has a risk of default (a default refers to a situation of a borrower not returning the money it has borrowed). We have seen this recently in Singapore, with a number of listed oil & gas companies going bankrupt, or looking to restructure their debt. When a company goes through debt-restructuring or bankruptcy, a bank that has lent it money may lose the entire loan amount or get only a fraction back.

Having said that, the bank is still liable to its depositors whenever they ask for money back. So, if a bank lends out a significant amount of its deposits, it is taking on a high level of default risk. Banks typically have a LDR in the range of 60% to 90%; this means that they are lending out 60% to 90% of their deposits.

Non-performing loans

The second metric is also loan-related. In fact, it can aid us in deciding what a suitable level for a bank’s LDR is.

Non-performing loans (NPLs) refer to the amount of borrowed money for which borrowers have missed scheduled payments for at least 90 days. An NPL can either be in default or close to being in default. The NPL is often used to calculate the NPL ratio, which is the ratio of NPLs in a bank’s loan portfolio to the total amount of loans held by the bank.

The NPL ratio gives investors insight on the quality of loans a bank is making. A high NPL ratio indicates that a bank’s credit department is not stringent with assessing the credit-worthiness of borrowers when issuing loans. In such a case, the bank’s LDR should ideally be lower to compensate for the risk.

A low NPL ratio, on the other hand, indicates that a bank is prudent when lending out money. It should also give investors confidence in the bank’s vetting process. The bank could thus work with a higher LDR.

A Foolish conclusion

There is no such thing as a magic number that can tell us whether a bank is a good investment or not. There are also many other important metrics beyond the two I discussed. But, those two can tell us important things about a bank’s risks. So, investors should still look at the two metrics carefully when studying 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.