The rising interest rate environment that we have been experiencing over the last two to three years has led to banking companies putting up good performances. Analysing industry-specific companies to make investing decisions can often be challenging due to the different metrics being relevant.
In this article, let us look at two metrics investors can use to make an informed decision when considering bank stocks.
The loan-to-deposit ratio is a critical ratio which investors should take note of. The banking business is essentially a business of loaning money. The banks collect deposits from all its customers and use this as capital, which is lent out. This means that the bank makes money by charging interest on the money that is loaned out and paying a fraction of it to its customers. The difference is then kept by the bank, which serves as its net interest income.
So, what does the loan-to-deposit ratio tell us and why is it important?
The loan-to-deposit ratio shows investors the amount of risk the bank is taking on. This is because with every loan, there is a chance of default, meaning the borrower might not be able to return the money. When this happens, the bank might lose the amount loaned out or get only a fraction back. Even then, the bank is still liable to its customers for their deposits.
What this means is that, if a bank lends a higher ratio of its deposits, it is taking on more risk in the form of default risk. Banks typically have a loan-to-deposit ratio in the range of 60-90%, meaning they are lending out 60% to 90% of their deposits. While there is no one number to be used as a gauge, investors should compare this ratio with other metrics to get a feel for the riskiness of the bank.
Since we are on the topic of loans, the second metric is also loan-related.
Non-performing loan (NPL) is the amount of borrowed money on which the debtor has not made his scheduled payments for at least 90 days. An NPL can either be in default or close to being in default.
Now that we know the definition of NPL, why is it important?
The NPL ratio gives investors a clue as to the quality of loans the bank is making. A high NPL ratio indicates that the bank’s credit department is rather “easy” in giving out loans and not checking the credibility of the borrower. In such a case, investors would want the loan-to-deposit ratio to be lower to compensate for the risk. A bank with a higher NPL ratio tends to do well when the economy is doing well. However, it suffers when the economy goes south as people who could afford the loans when the economy was doing well could suddenly start defaulting on their payments.
A low NPL ratio, on the other hand, indicates that a bank is prudent in lending out money. This should mean that these loans carry a lower risk based on historical data, giving investors confidence in the banks’ vetting process.
Usually, when a bank is more conservative in giving out loans, it harder for them to build up a loan book. This means that during periods where credible borrowers are hard to find, the bank might choose instead to hold onto the cash, resulting in lower revenue and earnings.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.