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Investing in banks? Here’s what I think you need to know

Some of the biggest companies in the UK are banks, and so most investors at some point in their careers will consider the financial sector as a place to deploy capital. However, although banks resemble other businesses in some respects, they do differ from sectors like retail or technology in material ways. Here’s what I think you need to know to get started.

Fundamental events

There are a number of macro variables that can dictate how successful a bank is. First there are interest rates. It should be no surprise to anyone that most banks make their money by providing loans to borrowers. The higher the national rate, the more money banks make. This makes them somewhat unlike other stocks, which tend to dislike higher interest rates (as the cost of borrowing for businesses goes up). 

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Another important fundamental factor to consider is banking regulation. For instance, the Thatcher-era ‘Big Bang’ deregulation of the sector had a profoundly transformative impact on banks, allowing the City of London to become one of, if not the most, powerful financial centres in the world. Similarly, it is widely believed that a Jeremy Corbyn-led Labour government would be hostile to banks, and would introduce extensive legislation to rein them in, leading to a sell-off of financial stocks.

Valuation techniques

When investing in a bank, there are essentially two factors you want to consider. Firstly, is your target efficient at making money? Secondly, is it well-insulated against adverse events? So in other words, what is the return, and what is the risk? Here are two metrics that you should use when analysing financial institutions.

Net interest margin (NIM). This is (arguably) the most important bank metric there is. It is simply the difference between the interest that banks charge on loans and the interest that they pay out to creditors. There are two main ways that banks can grow their NIM — loan growth (getting more customers to take out higher-rate loans) and deposit growth (getting more customers to deposit their money at lower rates). Banks like it when customers take out more loans than they deposit. As an investor, what you want is to see a steadily growing NIM. However, you should be wary of banks that are offering loans to customers with poor credit — sooner or later that will come back to haunt them. 

Non-performing loan ratio. This is a measure of a bank’s risk. A non-performing loan is a loan in default. Naturally, banks should want to minimise their exposure to bad creditors, but sometimes they do not. This can be either a result of deliberate mismanagement, or an inability to accurately quantify risk. Many financial institutions fell into the latter trap in the run-up to the financial crisis by exposing themselves to mortgages that they believed were low-risk, but in truth were high-risk. The ratio is simply the number of bad loans as a percentage of total loans. Healthy banks really should not have a ratio of more than 2%. 

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Neither Stepan nor The Motley Fool UK have a position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.