The Glossary Edition

Defining & explaining a few metrics you need to know for evaluating banks

Greetings! I’m happy to report Conversion Confidential has been getting some traction as of late. First, an old colleague reached out to me to let me know that the Manual of Ideas had linked to one of my posts (that explains a surge in visitors a few weeks back). MOI Global is an incredible community of sharp investors and puts out great content so I’d like to think I’m at least doing something right with this newsletter. Second, I’ve gotten to the point where there is some reader commentary and feedback, whether in the comments section of posts or directly to my email. It’s been rewarding so here’s to continuing to work to get the snowball rolling even faster!

Now, one thing a few readers have commented is that I don’t always spell out my acronyms, define terms, and/or would like a bit more info on how to evaluate various bank metrics. They are right. So consider this a surface level glossary of a few important terms. I’ll outline how they’re calculated, what they mean, and any other brief commentary that comes to mind. I’ve attempted to put it alphabetically, but sometimes there’s another idea/term that is closely related and I think it makes sense to place them in proximity to one another. Hope it helps!

Assets - If you’ve never looked at a bank balance sheet before, you may find it odd loans are considered an asset, but recall a bank earns income on the loans it makes. For most banks, loans will comprise a majority of total assets. Investment securities tend to comprise the second largest item.

Asset / Liability Sensitivity - A bank whose assets “reprice” faster than liabilities is said to be asset sensitive. In a rising rate environment, this means the assets would adjust to the higher interest rates quicker. This in turn increases the profitability of the bank due to the ‘spread’, or the difference between what a bank earns on its assets and what it pays on its liabilities (deposits and debt) increasing. A lower rate environment would have the opposite effect and a liability-sensitive-bank would be the inverse to the scenario outlined. Most banks tend to be asset sensitive.

Asset Quality - The overarching term (interchangeable with “credit quality”) used to assess a bank’s balance sheet. Banks get into trouble when their assets go bad (aren’t paid back by borrowers) which introduces losses to their earnings power and/or equity.

A few key ratios help better understand a bank’s asset quality including the NPL ratio, NPA ratio, and NCO ratio. Each will be defined and addressed in turn below.

Bank Holding Company - The corporate structure/entity that typically holds the subsidiary bank responsible for the actual day-to-day banking operations. Bank holding companies are what are listed on the public market exchanges for trading. They offer more regulatory flexibility in raising capital and/or paying dividends.

Brokered Deposits - Usually a certificate of deposit that is acquired through a broker or sales representative of another bank/institution. These deposits tend to be higher cost and are more likely to chase after higher yields. In short, they are lower quality deposits.

CAMEL(S) - An acronym used by bank analysts and regulators that outlines a high-level framework for evaluating a bank:

• Capital

• Asset quality

• Management

• Earnings

• Liquidity

• Sensitivity to market risk

Call Report - The term used to refer to the Consolidated Report of Condition and Income that all banks in the US must file for regulators on a quarterly basis. As I discovered in my NSTS Bancorp writeup, only the subsidiary bank is addressed by the call report, not the bank holding company.

Certificate of Deposits (CD) - A savings certificate which usually has a higher fixed interest rate and longer maturity date. Accessing CDs is typically restricted for the agreed upon timeframe or subject to fees. Another lower quality source of deposits.

Credit Quality - See asset quality above.

Commercial Real Estate (CRE) - In the world of thrifts this typically applies to residential multi-family properties above four units. It could also refer to other loans backed by commercial property collateral.

Core Deposits - A term used to describe the subset of all deposits which are more stable (less likely to leave the bank for a slightly higher yield) and a lower cost source of funding. Usually defined as all deposits minus CDs. The higher the ratio of core deposits to total deposits the better. Look for ratios of 80%+ for very strong deposit franchises.

Core Deposit Premium - The premium paid over tangible equity as a percentage of core deposits in an acquisition. Typically in the range of 5-15% although this varies depending on economic conditions. I wrote more about both core deposits and core deposit premiums here.

Dividend Yield - The annualized dividend per share divided by share price. Informs you of the cash return to shareholders (excluding share repurchases), at cost, before any tax implications.

Efficiency Ratio - Calculated as non-interest expense as a percentage of revenues (net interest income + non-interest income). You can think of this measure as the equivalent of operating expenses to revenues for an industrial company. The lower the efficiency ratio the better. Maybe it’s just they way my brain is wired, but I’ve always thought the name was a bit misleading (wouldn’t higher efficiency mean better?). Anyway, most banks probably sport efficiency ratios somewhere in the range of 50-65%. Thrifts are subscale usually have higher efficiency ratios at 70%+ which impairs their overall profitability. When you come across a bank with an efficiency ratio below 50%, it’s usually time to take note because it’s probably a well-run bank.

It’s also a good idea to compare non-interest expense as a percent of average assets. This will help remove any distortions between various banks that may have different operational focuses (and therefore difference margins and cost structures). Once again, lower is better.

Equity - Also known as book value. Simply the difference between assets and liabilities on the balance sheet. It’s the shareholder’s residual claim on the bank after deducting for all liabilities. Equity is also the last resort to absorb loan losses behind the loan loss reserve and pre-provision income.

Equity Ratio - Calculated simply as shareholder’s equity divided by assets. This is a simple and very common measure of a bank’s leverage. My personal preference is to see this ratio above 10% for increased safety. On the other hand, I would start to worry if it’s below 8%. Remember though, higher equity levels will also act as a drag on earnings and results in lower profitability as measured by returns on equity due to a lower equity multiplier (reciprocal of equity ratio).

Tangible Common Equity (TCE) Ratio - I tend to use the tangible common equity (TCE) ratio when evaluating banks. It removes intangibles and goodwill from the equity and asset calculations above because in a liquidation, intangibles would probably prove to have little inherent value. It’s slightly more conservative to use the TCE ratio, but often results in similar figures as the equity-to-assets ratio.

Initial Public Offering (IPO) - The initial sale of company shares to the public. Thrifts convert from mutual ownership to public stock ownership via IPOs.

Loan to Deposit (LTD) Ratio - Calculated as gross loans divided by total deposits. This is a quick measure of liquidity/riskiness inherent to a bank’s balance sheet. The higher the ratio, the riskier the balance sheet, all else equal. LTD ratios might ideally fall into the 80-95% range. Over 100% implies the bank maybe “over-loaned”, but it is also common to see thrifts over 100% because their loans are typically longer duration, lower risk (residential mortgage and CRE) and can be funded with Federal Home Loan Borrowing (FHLB) advances.

Loan Loss Reserve (LLR), aka Allowance for Loan Losses (ALL) - The amount a bank sets aside in order to absorb anticipated credit losses. The first line of defense. Provisions from the income statement are added to bolster the reserve, while net charge-offs (loan losses) are deducted from it. The ALL as a percentage of the total amount of loans should be compared to other similar banks to look for clues that a bank may be over or under-reserved. Also compare the ALL to Non-Performing Loans (NPLs). This is known as the reserve coverage ratio.

Market Capitalization - Calculated as shares outstanding multiplied by the current share price. Essentially the total amount you could purchase the whole business for if all shareholders were willing to part with the company at that price.

Mutual Bank - A community bank that is owned by its depositors rather than shareholders.

Mutual-to-Stock Conversion, aka Thrift Conversion - The process by which a Savings & Loan (S&L) or mutual bank converts to public ownership.

Net Charge-Offs (NCO) Ratio - The NCO ratio is another helpful tool in evaluating credit quality and may also be referred to as the loan-loss ratio. It is calculated by taking annualized net charge-offs and dividing by gross loans.

Charge-offs are the process by which a bank officially recognizes a poorly performing loan as a loss. They are deducted from the ALL, net of recoveries (which are previously charged-off loans that end up returning more than the bank anticipated).

Non-Performing Loans (NPLs) Ratio - NPLs are poorly performing loans where the borrower is behind on interest and/or principal payments. The bank acknowledges this state of affairs by ceasing to accrue interest income on the loan.

It’s a good idea to calculate the NPL ratio by dividing NPLs by gross loans and to compare this over time and/or versus peers. A bank will usually calculate and publish this ratio for you.

Non-Performing Assets (NPAs) Ratio - Sometimes used interchangeably with the NPL ratio, but typically implies real estate that has been repossessed by the bank is also included in the calculation. Calculated as NPAs as a percentage of total assets.

Other Real Estate Owned (OREO) - When a borrower defaults on a loan with property as collateral, the bank takes back the property through a foreclosure. Real estate that has accumulated on the balance sheet through this method is called OREO. It is held at its marked down value and should be added to NPLs to calculate the NPA ratio.

Reserve Coverage Ratio - Calculated as the ALL divided by NPLs. You’ll want to see it at 100% or more. In the dire scenario where essentially all loans the bank has identified as problematic do go bad, the bank is in theory covered by the reserves so they don’t take a hit to their equity levels.

Return on Assets (ROA) - Net income divided by average assets. This is the most common and quickest method to measure a bank’s profitability. Ideally, a bank earns a ROA of at least 1% (2% or more would be considered incredible in the current interest rate environment), but don’t expect to find many thrift conversions with that level of earnings power.

Return on Equity (ROE) - Calculated as net income divided by the average common equity. I tend to use tangible common equity. Along with ROA, ROE measures a bank’s profitability, but accounts for the leverage in the bank. In other words, it’s a measure of the return on capital that shareholders have invested into the bank. A 1.00% ROA combined with a TCE ratio of 10% would equate to 10% ROE (1% x 10). Returns on equity of 10%+ is a respectable goal for most banks, but again, you’ll find few thrift conversions earning those returns given their lower profitability and excess capital.

Texas Ratio - The Texas Ratio is used to assess whether banks in crisis remain going concerns. There are a few variations, but I think the best version is calculated by adding all NPAs (to include past due loans not categorized as NPLs yet) as well as restructured loans and dividing by the sum of tangible common equity and the loan loss reserve. A lower ratio is better and anything approaching or going over 100% is a big indicator to stay away!

Troubled Debt Restructuring (TDR) - Also known as restructured loans. When a bank makes accommodations to a borrower having trouble making payments by lowering their interest rate or altering their payment schedule, it is known as a TDR. These are not typically considered NPLs but they do have a higher propensity of ultimately becoming NPLs so watch for them building up at a bank.

Valuation - Some measure of the banks market capitalization to any number of various metrics, including, but not limited to:

• earnings

• book value/equity

• core deposits

Wholesale Funding - Sources of funding that include FHLB advances and jumbo and/or brokered CDs. A lower quality form of deposits/liabilities.

Yield Curve - A curve that shows the various yields and their relationships based on different government bond (Treasuries) maturities. Banks as a whole do best when the yield curve is gently sloping upwards because they “borrow short and lend long”. In other words, they take in lower cost, shorter-term deposits and lend them out into loans and investment securities with longer maturities at higher interest rates, capturing the difference, or ‘spread’.

This list is obviously not meant to be 100% comprehensive, but hopefully it elaborates on a few topics or acronyms you’ve seen me mention in passing, but that I haven’t explained very well. If you would like to learn more or there’s another term you’re still unsure of, feel free to drop me an email or leave a comment. Thanks for reading!