Why I won’t buy a single share of online banking

My colleague Michael Douglass recently published an article on why he won’t buy a single large bank stock, citing their drawbacks compared to lower cost online banking. What it says is true: Online banks have lower operating costs as a percentage of revenue than traditional brick-and-mortar banks a mile away.

In theory, the low operating costs allow online banks to be more competitive in lending at attractive interest rates, while offering higher interest rates to savers, simultaneously helping them to obtain loans. loans and deposits with large, underperforming banks.

But while online banks love BofI Holding (NYSE: AX) and Allied financial (NYSE: ALLY) may achieve better results than, say, Bank of America (NYSE: BAC) in terms of operating expenses per dollar of income, they score much worse when their expenses are compared to the size of their balance sheet.

And it is for this reason that I think online banks are likely to show unimpressive returns compared to their traditional banking counterparts over almost any sufficiently long investment horizon, especially in a rising rate environment. .

Efficiency rate failures

The efficiency ratio used by Douglass in his analysis is a preferred ratio for bank equity investors because it measures what a bank spends on non-interest expenses (branches, salaries, ATMs, utility bills. , etc.) as a percentage of net income. Banks that spend a smaller portion of their income on spending should have an advantage over those that spend more, other things being equal.

But the efficiency ratio also has two fatal flaws: it favors banks that provide higher-risk, higher-yield loans, and unfairly penalizes banks that use branches to provide low-cost deposits. It’s no surprise that credit card issuers, which earn high loan yields and fund themselves primarily through high-interest wholesale and online channels, have some of the highest efficiency ratios. lower. This does not mean that they are good banks to invest in; it just means that they are credit card issuers.

In short, an efficiency ratio is particularly useful for comparing the same bank to previous periods or for comparing competing banks with each other. If you only use the efficiency ratio to select bank stocks, you will end up with a portfolio full of auto lenders, subprime lenders, and credit card companies. It unfairly punishes the prototype commercial bank, which provides low-yielding (and safer) loans to businesses.

In my opinion, the best way to find good banks to invest in is to compare banks based on their spending as a percentage of their balance sheet, not as a percentage of income. When you define the efficiency in terms of a bank’s net spend relative to its size, you see why big banks have a real advantage over small online banks.

Image source: Getty Images.

A better way to analyze banks

Recognizing that banks ultimately make money from their balance sheets, I like to analyze banks by calculating their net expense charge as a percentage of their liabilities. A bank that finances its balance sheet at a lower cost can afford to lend at lower interest rates and take less risk to achieve the same returns, all other things being equal.

I use the following formula to calculate the total net cost of a bank’s liabilities. (You can also use this formula for deposits instead of total liabilities.)

(Total interest expense + total non-interest expense-total non-interest income) / Total liabilities

This formula corrects some of the shortcomings of a simple efficiency ratio. It recognizes that non-interest expenses (such as cashier salaries and ATM networks) help a bank generate deposits at a lower interest rate, and that these expenses are partially offset by non-interest income. of interest.

A funny thing happens when you use my method to analyze banks: Online banks far outperform traditional banks. This is because online banks spend more money on interest charges and have less means of generating non-interest income than traditional banks, resulting in higher net spending per dollar of liabilities, the “Raw material” of the banking sector.

Here is a table comparing Ally Financial, BofI Holding, and Bank of America over the past three years using my method. It’s not even close – the big bank wins.

Bank

2017

2016

2015

Allied financial

2.88%

2.68%

2.79%

BofI Holding

1.87%

1.49%

1.74%

Bank of America

1.24%

1.17%

1.28%

Data source: SEC filings, calculations by author. Percentages are calculated from year-end figures.

The reading here is that online banks Ally Financial and BofI Holding have to generate significantly higher returns on their loans and securities than Bank of America to get the same return on equity. And because returns and risk are intrinsically linked, it means that banks that spend more per dollar of liabilities have to take more credit risk to achieve similar returns.

The low cost producer can make a lot more bad loans, waste money putting their name on stages, and do various other “dumb things” while producing the same or similar income as their competitors. Low cost deposits and plenty of non-interest income (which offsets non-interest expenses) are the bank’s ultimate benefit. A low efficiency ratio may simply be the by-product of granting higher yielding (and riskier!) Loans.

Old banks in technological packaging

Basically, online banking attracts customers by offering high deposit yields, an approach that is neither new nor unheard of, although investors are apparently consumed by this “new” innovation.

In the American West, a special class of so-called “industrial banks” use state charters to receive deposits through high yield certificates of deposit. They operate from office buildings, not branch offices, and as a result, they have extremely low operating expenses, but they pay a high price for their deposits, so they are not exceptionally profitable.

Regular publicly traded banks use similar business models. In the countryside of New York, for example, a bank at a sleepy branch by the name of Bank of Utica has more than $ 823 million in deposits, about eight times the average banking industry deposits per branch. Over 71% of his deposits arrive at the bank through high yield money market accounts and CDs. With an efficiency rate of 35%, according to regulatory reports, it is one of the most efficient banks in the country (top 1% of its peer group), but you won’t hear about it because it doesn’t lacks the allure of online banking. This family bank was founded in 1927.

Online banks make it look like their business model is new, but paying higher rates to withdraw deposits without opening expensive offices predates online banking. As long as banks were able to compete by offering higher interest rates on accounts (since the deregulation wave of the 1980s), banks were able to increase their balance sheets without adding branches by attracting customers with high savings yields.

Don’t fall victim to recency bias

For more than a decade, virtually all banks benefited from low deposit costs because the benchmark interest rate was at zero. Banks that are good at making deposits had little advantage in a world where every bank paid next to nothing to borrow money.

This is changing, and I suspect that as interest rates rise, the deposit costs of online banks will rise much faster than the deposit costs of traditional banks. After all, the reason most people use BofI Holding or Ally Financial is precisely because they offer a high rate on deposits. Depositors moved to BofI Holding and Ally Financial to get a high return on their cash, and would likely move elsewhere if another bank offered a significantly higher rate.

As rates rise and the industry’s loan-to-deposit ratio rises to such an extent that deposit markets become more competitive, the gap between deposit costs at traditional banks and online banks will only grow. dig, exposing the danger of relying on efficiency ratios to determine the relative quality of a financial institution.

Say what you want from traditional banks. It might be silly to pay $ 12 per month for a savings account that pays 0.01% per annum on your deposits. But it has always been a stupid thing to do, and yet the big banks just keep getting bigger.

The Wall Street Journal recently reported that 45% of all new checking accounts opened last year were opened at three major national banks, which together held only 24% of all U.S. bank branches. Obviously, the decision-making process is not limited to choosing a bank with the highest return on a checking account, since almost half of all new checking accounts have been opened at three banks that rank close to. bottom for deposit returns.

Yes, online banks spend less on non-interest expenses as a percentage of income. This is obvious. But what is not always immediately obvious is that to keep operating costs low, online banks have to pay a market rate on deposits, which puts them at a disadvantage when interest rates are higher. to zero.

If I had a choice, I would take a basket of the Big Four banks against the online banks over any long-term investment horizon.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.


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David A. Albanese