In this introductory outline, we will give additional color on how we rank the banks and explain the methodology we use.
As many of you may know, our expectation is that the United States stock market will enter a prolonged bear market starting over the coming years. Moreover, the degree of bear market we expect is in line with the same degree of bear market begun by the 1929 market crash, which led to the Great Depression. However, our analysis suggests it can be a much more protracted event than even the Great Depression.
I want to start this preamble by highlighting several quotes which have driven the need for this service:
“Those who cannot remember the past are condemned to repeat it.” – George Santayana
“History doesn’t repeat itself, but it often rhymes.” - Mark Twain
“By failing to prepare, you are preparing to fail.” - Benjamin Franklin
Through our understanding of history, we have designed this service that will assist you in preparing for what may be a very difficult financial environment.
What we learned from the Great Depression, as well as the Great Recession, is that during times of severe financial distress, liquidity becomes an issue. This puts significant pressure upon our banking system, and many banks across the United States fail during these difficult periods.
Of course, many consider the FDIC as the backstop for such difficult times. But, did you know that the FDIC incurred losses of $35.1B and $38.1B for 2008 and 2009? Moreover, the Deposit Insurance Fund (DIF) balance went into the negative by $21B. It is important to note that this was during a relatively short bear market. Consider what the banking environment will be like once we enter a prolonged bear market, as we believe will happen. We surmise that investors would prefer a safer bank holding their hard-earned money, rather than relying on an FDIC insurance system that will likely be under extreme pressure and unable to assure full repayment.
So, to aid in one of the initial steps investors can take to prepare for an unprecedented difficult financial environment, we sought out some of the strongest banks in the United States. We have come up with this list of 15 banks out of a total of 4,000 banks that we believe can withstand the extreme financial pressures we foresee.
However, we must make it very clear that this service is NOT an investment advisory service. Our purpose is not to find banks in which one can invest. Rather, the purpose of this service is to identify some of the safest banks in the United States within which you can deposit your hard-earned money
Methodology and Ranking System
We are focusing on 4 main categories which are crucial to any bank’s operating performance. These are: 1) Balance Sheet Strength; 2) Margins & Cost Efficiency; 3) Asset Quality; 4) Capital & Profitability. Each of these 4 categories is divided into 5 subcategories, and then a score ranging from 1-5 is assigned for each of these 20 sub-categories:
If a bank looks much better than the peer group in the sub-category, it receives a score of 5.
If a bank looks better than the peer group in the sub-category, it receives a score of 4.
If a bank looks in-line with the peer group in the sub-category, it receives a score of 3.
If a bank looks worse than the peer group in the sub-category, it receives a score of 2.
If a bank looks much worse than the peer group in the sub-category, it receives a score of 1.
Afterwards, we add up all the scores to get our total rating score. To make our analysis objective and straightforward, all the scores are equally weighted. As a result, an ideal bank gets 100 points, an average one 60 points, and a bad one 20 points.
Below we explain the reasons why we believe these 20 sub-categories are so important for any bank.
Balance Sheet Strength
Loans-to-assets ratio. This indicator is calculated by dividing a bank’s total loans by its total assets. The ratio measures liquidity of a bank’s balance sheet. In a volatile environment, we would prefer banks with a lower loans-to-assets ratio as they are less likely to face liquidity risks and potential credit quality issues.
Securities-to-assets ratio. This indicator is calculated by dividing a bank’s total securities by its total assets. Banks cannot keep all of their free liquidity in cash as this would negatively affect their margins. As a result, some excessive liquidity is deployed into securities and interbank assets. From a balance sheet perspective, we prefer banks with lower shares of securities, given their volatility.
Loan-to-deposit ratio . This indicator is calculated by dividing a bank’s total loans by its total customer deposits. Loan-to-deposit is one of the most important ratios for a bank’s balance sheet strength as it is a key liquidity indicator. We prefer banks with a lower LTD ratio due to the fact that volatile periods have historically led to deposit outflows, and banks with high LTDs did face liquidity issues. We believe a loan-to-deposit ratio of 80% and below is quite a comfortable metric, an 80-100% range requires a deeper analysis and we would be cautious on banks with such ratios. We would avoid banks with an LTD of 100% and above as they are most likely to rely on wholesale funding.
Share of demand deposits. We prefer banks with a high share of non-interest bearing demand deposits. History shows that these deposits are “more sticky” and less sensitive to interest rate changes.
Share of IEA. We like banks with a high share of interest-earning assets. Such banks generally have much less exposure to non-core and non-banking assets which, in our view, tend to lead to additional risks.
Margins & Cost Efficiency
Net F&C income, as % of total assets. This indicator is calculated by dividing a bank’s net fee & commission income by its total assets. We prefer banks with a higher net F&C income/assets ratio as fees do not bear credit risk and are also less sensitive to changes in interest rates and in a broader macroeconomic environment.
Loan yield. This indicator is calculated by dividing a bank’s total interest income on loans by its average total loans. A higher loan yield translates into a higher net interest margin. However, if a bank has too many loans relative to its peers, then additional analysis is required due to potential exposure of high-risk lending.
Deposit cost. This indicator is calculated by dividing a bank’s total interest expenses paid on deposits by its average customer deposits. Similar to loan yields, the ratio also has an impact on net interest margins. In addition, banks with lower deposit costs generally have a safer risk-profile.
Net Interest Margin. This indicator is calculated by dividing a bank’s total net interest income by its average interest-earnings assets. The ratio is among the key performance indicators of any bank and its main earnings driver.
Efficiency ratio. This indicator is calculated by dividing a bank’s total non-interest expenses by its total operating income. The metric is very important for any bank and measures its operating efficiency. To put it simply, the lower the efficiency ratio is, the better a bank is with managing and controlling its noninterest expenses.
Cost of Risk. This indicator is calculated by dividing a bank’s total loan loss provisioning charges by its total assets or total loans. Together with ROE, NIM and efficiency ratio, COR is among the key performance indicators. It measures how risky a bank’s lending business is. Banks with a lower COR have better asset quality and more prudent credit risk management.
Loan loss reserve, % of total loans. This indicator is calculated by dividing a bank’s total loan loss reserve by its total loans. A loan loss reserve serves to cover negative impact from a borrower’s default. Obviously, banks with higher loan loss reserves would better withstand defaults in a volatile environment.
NPL ratio. This indicator is calculated by dividing a bank’s total non-performing loans by its total loans. A non-performing loan is a loan in which the borrower is either in default or has not repaid their loan in some time. A high NPL ratio is a sign of a high-risk lending business, and we obviously prefer banks with low NPL ratios.
NPL Coverage. This indicator is calculated by dividing a bank’s loan loss reserve by its non-performing loans. A high NPL coverage ratio indicates that a bank is well-prepared to absorb potential losses from its NPLs, while a low NPL ratio signals that a bank is likely to have difficulties with that.
Share of off-balance sheet items. This indicator is calculated by dividing a bank’s off-balance sheet items by its total assets. History shows that off-balance sheet items can cause serious issues for a bank (especially when these items are derivatives or uncovered guarantees). We prefer banks with a lower share of off-balance sheet items.
Capital & Profitability
CET1 ratio. This indicator is calculated by dividing a bank’s CET1 (Common Equity Tier 1) capital by its total RWA (risk-weighted assets). It is hard to overestimate the importance of a robust capital position in a volatile environment. It is well worth noting that risk-weighted assets are used as a denominator in the CET1 ratio formula, and, as a result, the ratio measures the risk of a bank’s balance sheet. To put it simply, each asset class has its own risk-weight. The riskier the asset is, the higher risk-weight it has (for example, a loan has a higher risk-weight compared to a UST bond or an interbank account).
Total capital ratio. This indicator is calculated by dividing a bank’s total capital by its total RWA (risk-weighted assets). A bank’s total capital consists not only of CET1, but also Tier 2 - level capital instruments, reserves, and preferred stocks.
Equity-to-assets ratio. This indicator is calculated by dividing a bank’s total equity by its total assets. The ratio is one of the most used metrics when it comes to evaluating a bank’s financial leverage. Obviously, banks with a higher equity-to-assets ratio would be more resilient to potential volatility.
Return on Equity. This indicator is calculated as a bank’s net profit divided by its average equity. Without a doubt, this ratio is the most popular key performance indicator as it measures a bank’s profitability or, in other words, how efficiently a bank’s capital is being used. It also measures a bank’s organic capital generation, which is very important in a volatile environment.
Return on Assets. This indicator is calculated by dividing a bank’s net profit by its average total assets. Return on assets is another measure of a bank’s profitability. It is used to compare profitability levels of banks with different financial leverage levels.
Red flags and why it was so hard to choose 15 really strong banks out of more 4,000
At first glance, our ranking system looks rather simple, and some might suggest that it could be automated. In fact, several popular websites are doing that, albeit they are using fewer metrics. However, that is not the case with us, and we would strongly recommend to all the readers to not just blindly apply our ranking system to measure a bank’s financial strength. We have quite a few banks with an 80+ score that eventually did not make it to our list as they have red flags, which are very likely to lead to major issues in a volatile environment. Below we would like to highlight some of these red flags and underpin the importance of a deeper analysis when it comes to choosing a really strong and safe bank.
Firstly, only banks with a 75+ total score have made it to our list. Secondly, as mentioned earlier, we exclude quite a few banks with a score of 80 and above. Here are some of the reasons for that:
We have carefully analyzed mortgage portfolios, and borrowers’ profiles in particular. We have excluded banks that have a focus on borrowers with low to even moderate income as such loans are more likely to turn into non-performing ones in a negative environment.
We have excluded banks with high shares of commercial & industrial loans and individual unsecured lending, as those are very risky types of credits, and they have been historically the most impacted by unfavorable macroeconomic changes.
We have excluded banks that have a high share of equities, non-US sovereign and corporate bonds, US corporate bonds or derivatives in their securities portfolio. We only recommend banks with securities portfolios consisting predominantly of UST and US municipal bonds. This is the area we suggest to watch very carefully, as we discovered that several banks which initially seemed very strong on our ranking system had very risky securities books. For example, one bank has significant exposure to emerging market bonds, while another has heavily invested into equities.
We have excluded banks with a high share of non-core assets.
We have excluded banks with exposure to derivatives through either their balance sheets or off-balance. It is hard to overstate the importance of a proper analysis of a bank’s off-balance, given that derivatives are often sitting there.
We have excluded banks that have significant exposure to non-deposit funding as those are very likely to face liquidity issues in a volatile environment.
We have excluded banks with loan yields that are much higher than the averages of their peer group. This is a sign that those banks are most likely working with very risky borrowers.
We have carefully analyzed historical dynamics of asset quality trends. We have excluded banks with volatile CORs and NPL ratios.
We have excluded banks that have one-offs in their P&Ls on a consistent basis.
We have carefully analyzed capital position and have excluded banks with high shares of complicated capital instruments such as AT1s and hybrids.
To sum up, our TOP-15 list is based not only on a 100-score quantitative ranking system but also on a deep qualitative analysis, and this is the main reason why it was so hard to choose 15 banks out of more than 4,000.
Please Note Regarding Our EU Bank Coverage:
There are slight changes in the methodology for the European banks due to peculiarities of their business models:
"% of Demand Deposits" in the "Balanсe Sheet Strength" category was replaced by "Liquidity Coverage Ratio (LCR)," which is a key liquidity ratio for European banks and is tracked by both the banks and the regulator.
"Loan yield" in the "Margins & Cost Efficiency" category was replaced by "Net F&C Income, as % of Operating Income," as European banks increasingly rely on fee income due to the current low interest rate environment in Europe.
"Deposit Cost" in the "Margins & Cost Efficiency" category was replaced by "Costs/Assets," which is an important operational efficiency indicator for European banks.
Please Note Regarding Our Canadian Bank Coverage:
"Net F&C Income, as % of Total Assets" in the "Margins & Cost Efficiency" category was replaced by "Non-interest Income, as % of Operating Income"
"Loan yield" in the "Margins & Cost Efficiency" category was replaced by "Non-interest Income, as % of Total Assets"
"Deposit Cost" in the "Margins & Cost Efficiency" category was replaced by "Costs/Assets"