MARKET COMMENT
Banks Hold The Key To The FTSE

By James Carlisle
July 18, 2002

The banking sector accounts for about a fifth of the entire UK stock market, so it's no surprise to find it at the centre of the market's recent turmoil. No wonder either that it's been leading the recovery over the last couple of days. All this brings the banks' half-year reporting season, which kicked off today with Northern Rock (LSE: NRK), sharply into focus.

In addition to their direct impact on the overall market, banks provide a useful benchmark for what's going on elsewhere. Through business and personal lending, and the potential for bad debts, they give a guide to the health of the corporate and consumer sectors. Through their life and asset management businesses they provide some insight to the health of financial markets (as if it were needed) and through mortgages, they reflect what's going on in the property market. So, if you want to have a guess about how markets will fare over coming months, then you'll want to keep a close eye on the banks.

It's as fashionable as it is sensible at the moment to focus on cash generation, but this doesn't really work with banks. After all, what exactly is cash? A bank's assets move steadily from being Bank of England deposits at one end of the scale to being advances to risky start-ups at the other. So there isn't the same easy distinction between 'cash' and 'other assets' as can be made with other companies.

The equivalent figures to look out for with a bank are its capital ratios. The most important of these is probably the tier one ratio. This expresses a bank's shareholders' funds as a total of its total 'risk-weighted' assets (ie, all the loans it has made, weighted to account for their risk). International standards say the ratio has got to be more than 4%, but that would be cutting things very fine. Generally you'd want to see more like 8%, with perhaps a little more for the banks operating in riskier areas. Of course, it's also important to see that it hasn't suddenly fallen over the last few years.

The trouble with this sort of calculation, though, is that it's virtually impossible for investors to double check. So you end up relying on the number quoted by the company itself and that's normally something you'd rather avoid. It's reassuring that banking authorities around the world take a close interest in getting the figure right, but it only gets you some of the way.

One advantage that banks do have over other types of business is that their net assets (subject of course to reliable provisioning for bad debts) are generally more easily quantifiable than for other businesses. That makes the return on equity figure a more useful guide to operating performance. The biggest risk to this is a sudden and unexpected rise in bad debts and provisions for anticipated future bad debts. So investors will be looking closely at these.

Given the difficulties with analysing banks, a lot of emphasis tends to get placed on their dividends. It's what's attracted investors to the sector recently and it has, for the moment at least put a floor to their valuations. But any sign over the next month that these dividends are not rock solid would undermine that. On the other hand, a full set of confident increases could spark some strong rises in the sector.