There are a number of misconceptions in the investment world that are specific to particular sectors.
One is that owning a casino is as risky as playing in one (it isn’t – keep your costs under control and the arithmetic, in the shape of the odds, will do the rest).
Another holds that real estate (“bricks and mortar”) is a sure-fire, fool-proof investment (wrong – as any number of property booms and busts have proved on both sides of the Atlantic).
Similarly, there is a view that investing in banks’ shares is a licence to print money. After all, isn’t that what banks themselves do?
Why large can be good
Well, there is some truth in that, as we shall see later. But the credit crunch and banking crisis that began in 2007-2008 ought to have disabused any financially literate person of the notion that banks are unsinkable investments.
True, the authorities in the US and Britain stepped in to bail out large banks, on the principle that their economic importance made them “too big to fail”. But they won’t do so again, and have put in place mechanisms to ensure that, if there is a next time, it will be shareholders not taxpayers who take the hit.
Nor should anyone thinking of investing or trading in the banking industry confuse the protection offered to depositors with the almost complete lack of protection that will be on offer to them.
So, what are the risks that banks face and, by extension, those who hold their shares?
The most obvious is what is referred to as bank-specific risk; the danger that a particular institution is being run incompetently, uneconomically or even fraudulently. How can the honest trader or investor avoid such banks’ stocks?
Well, if you’re really concerned on this score, it helps to stick to large, well known institutions. The likes of HSBC, Citigroup and UBS have such elaborate internal compliance and audit functions that it would be truly astonishing were any of them to be brought to their knees by mismanagement or financial misconduct.
In the former case, the credit cycle turns downwards as available funds dry up and asset prices start to fall. In the latter case, the banking sector has collectively misallocated credit to one or more types of borrowers who have proved to bring a high risk.
When it’s time to beware
Strangely enough, the 2007-2008 financial crisis combined both these types, which may explain why it was so destructive, and created the greatest economic emergency in 70 years. But, more on that in a moment.
First, the credit cycle. This describes the rise and decline of available credit in the economy, and, given that banks remain the primary provider of such credit, the cycle is of key importance to those investing in bank shares. If only everyone could agree on how long it lasts and where we are with respect to it at any one time, it would be a lot simpler to decide whether to buy, sell or hold the likes of Deutsche Bank, Santander, Sabadell, Unicredit, or, across the Atlantic, Morgan Stanley or Royal Bank of Canada.
Proponents of the former view allege that the unprecedented length of the current cycle is lulling people into a false sense of security and giving rise to the notion that the credit cycle has been abolished, in part due to central bank quantitative easing, which increases the money supply. All the conditions are in place, they say, for a violent downturn in credit conditions.
Those taking the mid-cycle view retort that a long cycle is not the same as a late cycle, and that buoyant business conditions and a low rate of company failures give the lie to the late cycle view.
For those with bank investments, the credit cycle – however defined – is hugely important, because as it turns down this will trigger a rise in corporate and individual bankruptcies, threatening the banks in two ways.
One is that bankrupt borrowers will be far less likely to repay their loans, and the other is that assets held as security by the banks, such as property, will fall in value as there is a scramble to sell them.
So, what of the other risk, that banks have made bad loans and these are now turning sour? There are plenty of examples of herd behaviour by banks, all piling into the same business sectors and all suffering when the sector in question proves a bad bet.
And, of course, on both sides of the Atlantic, it was sub-prime mortgages that provided the combustible material for the 2007 credit crunch and all that followed.
How can the trader or investor spot the signs of potentially dangerous “bubble” lending? There is no substitute for the careful study of annual reports and the financial media. When a suspiciously large number of different banks are enthusing about shopping centres, or the leisure industry, or lending to Latin America, or anything, it is time to beware.
The financial crisis, as mentioned, featured both a credit-cycle downturn that few had foreseen and a colossal misallocation of capital by the banks, many of which required vast sums of public money to survive.
Assets and liabilities
For the investor or trader, a detailed knowledge of the inner workings of the banks is no more necessary than a pilot’s licence for someone trading the stock of International Airlines Group. But it is important to correct two misconceptions about how banks actually operate.
The first of these is that banks take in deposits from savers and lend them out to borrowers, making their money on the difference between savings rates and borrowing rates, thus the old “3-6-3” adage of the small-town banker: pay 3% on deposits, charge 6% on loans and be on the golf course by 3pm.
In reality, most banks operate on the basis of what is called fractional reserve banking. Someone deposits £100, the bank lends out £90, because on average savers will, at any one time, ask for only 10% of their money, and that £90 is itself deposited.
This, in turn, forms the basis of £80 of lending, which is then deposited…and so on. This is the “licence to print money” mentioned earlier.
When times are good, this model works well. But, as seen in the crisis, it can be highly unstable when times are bad.
Another misconception arises from the language that banks use. In your own life, you would probably consider money in your pocket as an asset and any debt you may have as a liability. Banks do the opposite – when you read a set of accounts published by a bank, the “assets” are actually the loans they have made to borrowers, while “liabilities” comprise the money that savers have on deposit with that bank.
If all this sounds a bit daunting, it shouldn’t. Banking is a fascinating industry and trading bank stock can be very profitable for those prepared to do their homework. So, best of luck as you buy, or sell, the likes of Royal Bank of Scotland, ING, Credit Agricole and Banco Bilbao.
Finally, never forget the enduring wisdom of market veterans: the time to worry about the next financial crisis is when the last person to remember the previous one has retired.