North America
United States
Financial
Banks
11 May 2011
US Large Cap Banks
Banking 101
Matt O'Connor, CFA
Research Analyst(+1) 212 250-8489matthew.o-connor@db.com
Adam Chaim, CFA
Research Associate(+1) 212 250-2966adam.chaim@db.com
Robert Placet, CFA
Associate Analyst(+1) 212 250-2619robert.placet@db.com
David Ho, CFA
Research Associate(+1) 212 250-4424david.ho@db.com
Deutsche Bank Securities Inc.All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from localexchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. DeutscheBank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firmmay have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a singlefactor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1.MICA(P) 146/04/2011.
Special Report
Understanding banks and bank stocks
In this (98 page + Appendix) report, wediscuss how to analyze banks and bankstocks. We discuss key topics including:what drives bank revenues, trends incapital, credit and liquidity, the impactfrom regulation (both current andhistorically), interest rates, how bankstocks are valued and how bank stockstrade.
C o m p a n y
G l o b a l M a r k e t s R e s e a r c h
North America
United States
Financial
Banks
11 May 2011
US Large Cap Banks
Banking 101
Matt O'Connor, CFA
Research Analyst(+1) 212 250-8489matthew.o-connor@db.com
Adam Chaim, CFA
Research Associate(+1) 212 250-2966adam.chaim@db.com
Robert Placet, CFA
Associate Analyst(+1) 212 250-2619robert.placet@db.com
David Ho, CFA
Research Associate(+1) 212 250-4424david.ho@db.com
Understanding banks and bank stocks
In this (98 page + Appendix) report, we discuss how to analyze banks and bankstocks. We discuss key topics including: what drives bank revenues, trends incapital, credit and liquidity, the impact from regulation (both current andhistorically), interest rates, how bank stocks are valued and how bank stocks trade.Deutsche Bank Securities Inc.All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from localexchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. DeutscheBank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firmmay have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a singlefactor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1.MICA(P) 146/04/2011.
Special Report
Back to the basics: net interest income to be key driver of revenues
Net interest income represents about 65% of total revenue at the banks. After twodecades (i.e. the 1990s and 2000s) of trying to diversify away from net interestincome and into fee revenue, net interest income is likely to be the key driver ofrevenues going forward given regulatory changes have reduced fee revenue andlikely less asset turnover from here (which generates fees).
M&A has helped banks become more efficient, but more may be needed
Efficiency ratios averaged about 60% in 2010—similar to the average of the past20 years. This is down meaningfully from the nearly 70% level banks averaged formuch of the 1980s. A meaningful amount of this improvement likely reflectsconsolidation as data supports that bigger banks are more efficient. With revenuepotentially a challenge for many years ahead, becoming more efficient will be akey driver of profitability and growth. And while the number of banks has beenreduced by 55% since 1984 to nearly ~6,500 (including ~1,000 that are public),the number of branches is up 50% (vs. a 30% rise in the US population).
Bank stocks and interest rates
There has been weak correlation between daily changes in interest rates and bankstocks. However, there does seem to be fairly strong correlation during periods ofmeaningful changes in interest rates. In general, bank stocks underperform whenrates rise materially and outperform when rates decline sharply.
Profitability (ROAs and ROEs): Why Normal Isn’t Normal
Many banks are targeting ROAs going forward similar to what they generated overthe past 20 years—or about 1.25%. However, this seems optimistic to us giventhe historical period most look to (the early 1990s to 2006) included severalpositive macroeconomic trends that boosted bank profitability—many of which areunlikely to be sustainable going forward. As a result, we think normalized bankROAs will be lower (we estimate closer to 1%). Also see our Weekly CheatSheets for historical ROAs and targeted ROAs by bank.Interestingly, since 1935, there were only 14 years where the banking industry hadan ROA above 1% (from 1993-2006). This compares to a long-term average ROAfor banks of just 0.75%. Additionally, bank return on common equity (ROCE) since1935 has averaged just 10% (vs. 13.7% from 1993-2006).
Our key products
1) Bank Cheat Sheets (Weekly). Analysis of key trends—refreshed regularly tofocus on what’s relevant at any given point. The staples include metrics onbalance sheet mix, interest rate risk, market share, credit, capital, and valuation.We also include mgmt outlook comments and our current model assumptions.2) Question Bank (Quarterly). A page of key questions for each bank we cover.3) Bank Bull….and Bear. 3 positives and 3 risks for each bank we cover.
11 May 2011 Banks US Large Cap BanksPage 2 Deutsche Bank Securities Inc.
Table of Contents
Summary............................................................................................4
How a Bank Makes Money...............................................................6
Revenue Components..............................................................................................................6
Net Interest Income—the Largest Source of Revenue at Banks..............................................6
Net Interest Margin...................................................................................................................6
Loans........................................................................................................................................8
Securities..................................................................................................................................9
Deposits..................................................................................................................................10
Noninterest Income (i.e. fee revenue).....................................................................................11
Recent Changes to Regulation of Bank Fee Income...............................................................12
Expenses................................................................................................................................13
Interest Rates and Banks................................................................15
Interest Rates - Impact on Loans............................................................................................15
Interest Rates - Impact on Deposits.......................................................................................17
Interest Rates - Impact on Net Interest Margin (NIM).............................................................19
Interest Rates - Impact on Securities......................................................................................19
Interest Rates
-
Impact on Credit Costs
.................................................................................20
Bank Interest Rate Sensitivity.................................................................................................20
Yield Curve
-
Impact on the Carry Trade
.................................................................................21
Yield Curve
-
Impact on Earnings
............................................................................................24
Yield Curve
-
Impact on the Balance Sheet
............................................................................24
Yield Curve
-
Impact on NIM
..................................................................................................26
Yield Curve
-
Impact on Credit Costs
......................................................................................26
Asset-Liability Management....................................................................................................27
Managing Interest Rate Risk...................................................................................................28
Capital...............................................................................................30
Types of Non-Common Capital:..............................................................................................30
The Roles of Bank Capital.......................................................................................................31
Key Capital Metrics (Regulatory and GAAP)............................................................................32
How Regulatory and GAAP Capital Differ...............................................................................34
What Causes Banks’ Capital Ratios to Increase/Decrease......................................................35
How Much Capital is Enough?................................................................................................35
How Regulatory Capital Requirements Have Changed Over Time.........................................36
Issues with Basel I..................................................................................................................38
What Will Future Capital Requirements Look Like (Basel 3)...................................................40
Credit................................................................................................42
Measuring Bank Credit Risk....................................................................................................42
A Snapshot of Past Recessions/Credit Cycles........................................................................49
Liquidity............................................................................................50
Capital is King, But Liquidity Rules..........................................................................................50
How Banks Estimate Liquidity Needs.....................................................................................51
Bank Liquidity Ratios Have Deteriorated Over Time...............................................................53
Legal Reserve Requirements..................................................................................................54
More Stringent Liquidity Regulations Likely in the Future.......................................................54
Liquidity Coverage Ratio.........................................................................................................55
Net Stable Funding Ratio........................................................................................................56
Bank Regulation...............................................................................59
Why Banks Are Regulated......................................................................................................59
Who Are the US Bank Regulators?.........................................................................................59
Regulatory Filings and Ratings System...................................................................................65
Important Legislative Actions in Banking................................................................................66
Costs/Benefits of Regulation..................................................................................................70
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