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What Retail Banks Tell Us About the Economy
Learn how to breakdown banking earnings and gain insight into the market - Est. reading time 9:29 minutes
Retail banks provide financial products and services to roughly 75–80% of the American population and can act as a bellwether for the economy at large. Two key indicators from retail banks, liquidity, and provisions, provide insight into a bank’s view of the economic condition. These indicators can be broadly assessed by using a combination of four key metrics: non-performing loans, loan-to-deposit ratio, coverage for bad loans, and the net charge-offs rate.
Retail banks have long been lauded as pillars of economic growth that may provide indications about economic expansion and contraction. Also known as consumer or personal banks, retail banks are primarily focused on deposit products and services that most of us are familiar with such as checking and savings accounts, deposits, and loans (e.g. Bank of America, Wells Fargo). They differ from commercial or investment banks that focus on corporate financing, wealth management services, and capital markets (e.g., Goldman Sachs, Morgan Stanley). Although retail banks may offer complementary products, such as insurance services, wealth management, merchant services, commercial loans, treasury services, or corporate products, their bread and butter is in “people” banking.
Retail banks provide financial products and services to roughly 75–80% of the American population and are therefore critical underpinnings of the economy. Banks can provide the general public with insight into the current state of affairs by reflecting the financial health of the average person, acting as a bellwether for the economy at large.
Retail banks generate revenue by holding, investing, and leveraging financial assets to create and further wealth through financial instruments such as insurance offerings, mortgages, investment vehicles, credit cards, and loans among other offerings. In doing so, banks provide two key indicators that hint at their economic outlook, liquidity, and provisions.
Liquidity refers to the ease with which an asset can be converted to ready cash to meet any short-term needs. In the context of retail banks, this is how the bank allocates its assets or how much of its liquid assets the bank is willing to put into action. This can be interpreted as a simplistic proxy of how confident the bank is about the current state of affairs. It is the bank’s version of “put your money where your mouth is.” The second concept, provisions, represents the other side of the coin. Provisions are the amount set aside for probable or potential liabilities. This is the “rainy day” fund to pay for anticipated future losses.
Together these two overarching concepts can be viewed to derive how a bank may be strategizing for or against future events. In particular, there are four widely available metrics that can be found in all quarterly and annual reports that shed light on liquidity and provisions:
Non-performing loans (NPL)
Loan to deposit ratio (LDR)
Coverage for bad loans
Net charge-off rate (NCO)
Although these ratios are not exhaustive, they are a good place to begin understanding a bank’s operations and overall thinking. These metrics can be used to indicate a substantial movement in the overarching direction of the market in the short and intermediate-term.
Non-performing loans (NPL):
NPLs examine loans in which the borrower has not made a payment in at least 90 days and is approaching default. Banks issue loans to generate revenue from interest payments, if borrowers stop making payments banks lose out on revenue. In turn, banks will be more conservative when issuing loans to reduce additional risk.
Why NPL matters: NPL is the first indicator of a potential shift in the economic cycle, and by the time it is being discussed by business news anchors, things are already in motion. The higher the amount of non-performing loans the worse the state of the bank’s loan portfolio. If NPL rates are rising across all banks, it is a signal that people and businesses may not be able to afford to pay back their loans and we may be on the verge of a crisis. Think of it as a minor fever, it might be nothing but there is a chance that there is something worse at play.
On the other hand, a sustained decrease in NPLs indicates that either people are able to pay off their loans or banks are simply adapting to a more conservative strategy. The NPL, in combination with the following metrics, can help shed light on which it is and whether or not the worst is behind us.
Calculating NPL: (non-performing loans / total loans) * 100
How to make sense of the NPL: In times of relative economic stability, the NPL will hover around 1–2%, closer to 1% for most retail banks. During an economic crisis, this metric is expected to increase up to 3–5%. Anything above 2% is something to worry about. In perspective, during the 2008–2009 financial crisis, non-performing loans peaked at 5.6%.
Loan to Deposit Ratio (LDR):
LDR compares a bank’s total loans issued to its total deposits for a given period of time, represented as a percentage. Banks use their deposits to issue new loans, if a bank has a low LDR it indicates that the bank is likely holding onto their deposits either due to low demand or they are not maximizing their potential revenues on their holdings. A ratio that is too high raises concerns because the bank may not have the necessary cash at its disposal for an unexpected event requiring ready funds such as a “bank run.”
Why LDR matters: During economic downturns banks tend to reduce their loan offerings, making them harder to obtain as higher, and stricter parameters are used to minimize the risk of non-performing loans. In times of hardship and increasing unemployment, borrowers are more likely to default on their debt (credit cards, mortgages, business, auto loans, etc.) Banks will naturally act to minimize their exposure to defaulting loans and will retain more cash. In times of economic growth and prosperity, banks will likely lend out more money as default rates decline and banks have more confidence in the economy. This creates more permissible loans that may end up in the NPL book. The bottom line is a bank’s LDR is often interpreted as a reflection of its confidence in the current state of the economy.
Calculating LDR: (Total Loans / Total Deposits) * 100
How to make sense of the LDR: Although there is no regulatory minimum, the LDR typically hovers between 70% and 90%. An LDR of 1 indicates that the bank is lending every single deposited dollar and will most likely have trouble coming up with the cash in unexpected circumstances. As a rule of thumb, the bigger the bank (largest market capitalization), the higher the LDR. Larger banks tend to have an LDR of around 80–90% while smaller, regional banks are typically more conservative with an LDR of around 70–80%. The reasoning is mostly due to the diversification of risk among more clients.
Coverage for bad loans (aka Provisions Coverage Ratio):
Provisions Coverage Ratio indicates how prepared the bank is to confront potential losses from non-performing loans. It represents how much the bank has set aside as a provision of loans issued that may end up not being paid. This is the bank’s way of calculating and deciding how big the “rainy day” fund is.
Why Coverage for bad loans matters: The ratio serves as both a micro and macro indicator. On a micro level, it represents an individual bank’s strategy and confidence in its loan portfolio. On a macro level, the trend of a bank’s provisions over time can provide a view into the direction of the economy. If a bank that typically provisioned 100% coverage is now provisioning 200% for the upcoming quarter and the NPL ratio has started ticking upwards, a bank could be recovering from a downturn, changing strategies, or bracing for impact. Like the other metrics, this metric should be analyzed in conjunction with other indicators to identify what is happening.
How to calculate Coverage for bad loans:
(total provisions / total non-performing loans) * 100
How to make sense of Coverage for bad loans: It is an industry expectation that banks should be able to cover at a minimum, 100% of their potential NPL losses. This means that the ratio should be at 100% and anything below 100% is worrisome. More conservative banks will cover over 150% of their expected NPLs.
A bank’s provisions are its insurance policy. Hopefully, the bank does not have to use it, but it is essential in case the worst comes to worst. Anything less than 100% coverage is risky, and anything over 100% helps you sleep at night.
Coverage for bad loans is best analyzed as a relative ratio; that is to determine appropriate levels you must compare the coverage/provisions ratio across similar banks over time to determine where the outliers and issues are.
Net Charge-Offs Rate (NCOs rate):
NCOs rate is a measure of the loans a bank does not expect to recover. These borrowers have not made a payment in the past 6 months and are considered delinquent. The term “net” is used to account for the difference between total charge-offs and any recoveries on the delinquent debt.
Why the NCOs rate matters: The NCOs rate provides further depth into delinquent debt and non-performing loans. A percentage of non-performing loans will end up being written off. The NCOs rate is the last to peak, and therefore, a great indicator for spotting when the best or worst of the current cycle is over. Think of NCO’s as the whiplash of an economic swing. During the financial crisis, the NCOs rate climbed for over 2 years until it peaked towards the end of Q1–2010.
How to calculate the NCOs rate: (Total net charge-offs / total loans) * 100
How to make sense of the NCOs rate: Charge-offs are made when the bank gives up hope of being paid back. The NCO rate will vary depending on the type of loans the bank predominantly issues. The peak NCOs rate due to the 2008–2009 financial crisis was slightly over 3%. In early 2018, the rate was around 0.5%. Similar to the coverage/provisions ratio the NCO rate must be assessed relative to similar banks however, a lower the NCOs rate is typically a good sign.
Now it is your turn, these 4 metrics can provide an investor with insight into the current economic cycle and what may come. When banks release their earnings, keep your eye out for these metrics and what they could be telling you!
A few tips to help you on your journey.
To form a holistic view of the situation, compare this information to other general macroeconomic indicators to make more sense out of them, and differentiate bank risk from general market risk.
More general indicators such as unemployment, housing starts, and mortgage applications will shed light on the bigger picture.
Finally, it is critical to look at these metrics both comparatively to other competing banks, as well as over time (QoQ or YoY) to better understand the trend.
Depending on your interests, these metrics can be applied to large banks, like Wells Fargo or Bank of America, to get a notion of the direction of the general economy or at a micro-level looking into regional banks, such as Lakeland Bancorp, Eagle, or Century Bank to name a few, if you are concerned about your area in particular. In studying a microenvironment, trends tend to play out quicker and can serve as a tool to better understand impending trends for the economy at large.
Interested in learning more? Check out the articles below for some real-life examples of how banks have planned for liquidity and provisions this year.
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