Every year, the analysts at m.rae resources analyze close to a thousand community banks. This is done for speeches we make, classes we teach, and one-on-one meetings with bank leadership teams. We believe that every community bank’s balance sheet and income statement sends specific messages on the uniqueness of the risk/return tradeoff at each community bank. The story is told through the following observations.
Observation 1: Non-current loans as a percentage of loans
The first chapter is to evaluate if your bank has a level of non-current loans that is higher or lower than the national average. If it is the same or higher than the national average, we would be concerned that the bank has taken a high level of credit risk. In the aftermath of the financial crisis of 2008 and 2009, the ensuing recession shows your bank’s true level of credit performance.
Observation 2: Level of cash-type deposits
Looking at the level of cash-type deposits is a way to gauge the “quality of earnings” at your bank. (Cash-type deposits include those “sticky” lower-cost checking, savings, and money market accounts.) Quality of earnings would not only include the net interest margin but would also include the volatility of the margin and the bank’s liquidity risk. Cash-type deposits of less than 50% of deposits would have weak earnings quality. We consider community banks with 60% plus in cash-type deposits to have strong earnings quality.
Observation 3: Cost of funds
To further our views on earnings quality, an evaluation of cost of funds and its trending versus a national benchmark of all community banks is important. If your cost of funds has been consistently below national trends, this will confirm the earnings quality view from the cash-type deposit evaluation. If it is higher, dig deeper into your level of borrowings and repos. We would also look at the cost of deposits and the cost of borrowings. This further reveals insight into liquidity risks and earnings at risk.
Observation 4: Loans to assets
To further understand credit risk, look at your loans to assets. We would consider 60% to 65% to be lower risk, 70% to 75% as moderate to high risk, and greater than 75% suggesting high risk. Then examine your mix of loans. We refer to the m.rae loan mix that is based on the study of the past 30+ years of conservative banking. This loan mix is 80% of loans backed by real estate. Commercial real estate and home mortgages would be split at 50/50 and comprising 77% of the 80%. We like to see less than 3% of loans committed to construction and development. C&I loans should be 12% or less. With these ratios in mind, compare it to the bank’s level of non-current loans. This is the next step in assessing the bank’s level of credit risk.
Observation 5: Loan yield
With this assessment of credit risk, look at your bank’s loan yield. Compare your loan yield to the national community bank loan yield. Then ask yourself if your bank has been compensated properly for the level of risk assumed.
Observation 6: Level of equity to assets against risk-based capital
To round out the assessment of risk, look at the levels of the bank’s equity to assets and risk-based capital. Does your bank have a reasonable level of capital to cushion the bank against our assessment of credit risk, earnings at risk, and liquidity risk?
Observation 7: Net overhead
Net overhead is the difference between non-interest expense and non-interest income. We like to see net overhead below 1.75% of assets. If your bank is above 2.25%, look to see if non-interest income is out of balance with non-interest expense. It is important to note that high levels of non-interest income that result in high levels of net overhead is not impressive. This should give you insight into how effectively your bank is being managed.
Observation 8: Historical trend in tax burden
Looking at the bank’s historical trend in taxes paid, has your bank been tax efficient? If you have an effective tax rate between 18% and 22%, you should grade your bank as excellent. Anything 30% and above would suggest that your bank has room to profit from being more tax efficient.
Observation 9: ROAA and ROAE
Looking at your historical trends in ROAA and ROAE should confirm the results of the previous steps of analyzing your bank.
Your balance sheet and income statement send specific messages on your risk/return tradeoff. What is your story telling you?