《金融时报》我为何不持有银行股

The seems like a good week to explain why I don’t own bank shares. Although it is seven years since the onset of the financial crisis, around 24-25 banks in Europe still have insufficient capital, according to the latest European Central Bank “stress tests”.

I’ve often been asked why I won’t invest in bank shares given that I was once the top-rated rated banking analyst in the City. The answer is that having an understanding of banks would make anyone more wary of investing in them.

One of my basic tenets is never to invest in a business which requires leverage or borrowing to make an adequate return on equity.

Most of the companies that we invest in at Fundsmith have some borrowing. But they do not require it in order to survive, and they make decent returns before the use of debt, rather than making small returns on their assets and then financing most of those assets with debt.

Banks rely on leverage to a greater extent than any other business. A 5 per cent equity to assets ratio for a bank is leverage of 19 in debt to 1 of equity.

The good news about such high leverage is that when something goes wrong, at least you go bust quickly.

Have a look at this very simplified bank balance sheet for Lloyds Banking Group at the end of 2013:

This is not unusual. It is the normal banking model. A bank makes a small return, typically 1-2 per cent, on its total assets, but as 95 per cent of the assets are funded by depositors and bondholders, the return on equity is much higher. A return of £1 on £100 of assets is a return of 20 per cent on the £5 of equity capital.

Which is all fine – until something goes wrong. Then a loss of just 5 per cent of the value of the assets means the shareholders’ equity is wiped out.

A more pernicious threat is a run on the bank. Investors had forgotten about the credit cycle until 2007, and when credit is withdrawn sometimes it is withdrawn from banks as well as their customers.

When I was analysing banks in the 1980s it was possible – by studying the bank’s accounts and regulatory returns – to gauge a bank’s exposure to bad debts or credit risk, interest rates and currencies. With the advent of over-the-counter derivatives in these products, which began with interest rate swaps in the 1980s, this is no longer possible.

Someone working in the bank’s treasury department may have altered all those exposures with a phone call or the click of a mouse and there is no way for investors to know. Judging by the events of the financial crisis, it is clear that a fair few bank managements were in the dark too.

All of which leads me to suggest that if you are going to own any bank shares, they should be in retail banks which simply take deposits, lend money to their own customers and make payments for them.

Such banks do exist and if I had to invest in a bank, that would be where I would look. But even those institutions are not immune to the threat which can arise from so-called systemic risk. They can be brought down by a run caused not by their own misjudgements, but by those of other banks in the system.

The fragility of banks is illustrated by a story from the 1980s, when there was a wave of nervousness in Hong Kong following the signing of the joint declaration regarding the colony’s handover to China. Property prices began to collapse and banks ran up bad debts as result.

During this febrile period, a queue of people waited for a bus. It started to rain, and the queue moved across the pavement to shelter under the cover of a canopy on a building, which happened to house a branch of a local family-controlled bank. Passers-by, seeing the queue, concluded that there was a problem with the bank. Rumours of a run spread rapidly and by the following day the bank was besieged by depositors demanding to withdraw their savings.

Terry Smith

Fundsmith