Twitter is abuzz with comments that SA banks look cheap, so let me try to explain banking in 800 words. The traditional banking model is to obtain funding by attracting retail deposits and issuing wholesale money market instruments. That money is subsequently lent out at a higher rate. The difference is called net interest income (NII) and the ratio of this income to average interest-earning assets is called net interest margin (NIM).
The complexity is that the bank can focus on both sides of the NII equation. For example, access to cheaper funding means that the bank can either expand its NIM (as the cost of money is lower) or maintain its NIM while cutting the pricing of its debt to consumers and thus rapidly growing its book.
The cheapest form of debt for a bank is retail deposits and especially current accounts, as the bank pays almost zero interest on the balance you have after your debit orders have assaulted your salary. Higher-LSM customers are more valuable to a bank from a cost of funding perspective than lower-LSM customers who live month to month.
Remember when FNB offered special offers on iPads and so on under Michael Jordaan’s leadership? Other than digitalising the customer base and annoying everyone with those Steve ads, it also went a long way towards attracting higher-LSM customers and lowering the cost of funding for the bank. Draw a long-term chart of FirstRand against the other banks and note how the price/book multiple in FirstRand spiked from 2012 to 2015. It has remained structurally higher than its peers since then.
Lower-LSM customers are valuable to the other side of the NII calculation. Sadly, they often run out of money and need unsecured loans, which the banks can load up with credit insurance and funeral policies. This is a space that is highly scrutinised by regulators to prevent the banks behaving badly, but even good behaviour can be highly profitable.
In a rising interest rates cycle, the endowment effect is critical. Absa has confirmed that its NII increases by R700m for every 100 basis point rate increase.
This is for two reasons. First, banks have equity on their balance sheets (like retained earnings) that doesn’t carry an interest charge, so these funds can be lent out at a higher rate without an associated funding cost. Second, loans linked to prime are priced higher as rates increase, but the rate paid on deposits doesn’t increase by the same amount. You don’t suddenly earn 1% on your current account just because rates went up.
Tongue-in-cheek, the ultimate NII model is to borrow cheaply from richer people and lend at high rates to poorer people. The market always has checks and balances, in this case the credit loss ratio (credit losses divided by average advances). If the bank’s credit models are broken, then the benefits of a great funding mix can be eroded by customers defaulting.
In managing the credit loss ratio, banks apply macro risk lenses (what should our exposure be to home loans?) and micro lenses on a customer-by-customer basis.
The macro lens combines broader economic themes with the bank’s strategy to maximise its interest income. A bank that focuses only on risky lending can blow up (like African Bank) and a bank that focuses only on low-risk lending probably won’t make enough money for its shareholders.
In general, NII after credit (or impairment) losses is usually lower than operating expenses. In other words, the bank is not profitable without the other type of income: noninterest revenue (NIR).
This is a bit cheeky, as some of those expenses are directly linked to earning NIR. Nonetheless, the important concept is that banks focus strongly on NIR to reach return on equity (ROE) targets. Everything from trading revenue in the global markets division through to insurance brokerage and asset management fees in the wealth division would belong in this bucket. Though there are no credit losses as money isn’t being lent out, there can be significant fluctuations based on market conditions.
Periods of high market volatility are great for NIR. Rising interest rates are great for NII, provided the credit loss ratio doesn’t run away. Banks are also laser-focused on bringing the cost-to-income ratio down through managing operating expenses, which is where Capitec has been the clear winner.
To assess bank share prices, my favourite approach is to combine ROE with the price-to-book ratio. For example, Nedbank’s ROE is 11.7% and price-to-book is 0.85, so the effective ROE at the current share price is 13.76%. Absa’s ROE is 15.3% and price-to-book is 1, so the share price looks cheaper than Nedbank as the effective ROE is higher.
There’s far more to it, of course, but hopefully this gives you a framework to get started in understanding banks properly.