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Banking shares – what to look for

We look at what investors need to know when looking at banking shares.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

It’s important to understand how a company ticks before investing. Lots of investors will be able to understand what’s going on with headline numbers in a set of results – revenue, profit and the like. But different types of companies have different figures that are important to understand.

Knowing what to look for in a bank’s full year results is very different to what you’d look for at a tech company.

But it’s not as complicated as you might think.

Why do interest rates really matter for banks?

Interest rate increases are good news for banks. But to understand why, we need to dig a little deeper.

An important figure when looking at banking results is the Net Interest Margin. This is the difference between what a bank can charge on its loans and the rate it receives for its deposits. That means a low interest rate environment is a headache. That’s because banks make money by lending money out at higher rates than they pay on deposits and low rates give them less room for manoeuvre.

The other key figure to look at for a bank is the amount of interest-bearing loans they’ve made in the period. This tends to be labelled ‘loans and advances to customers’ in results. Together with the net interest margin being achieved, this is what makes up a bank’s interest income.

Not all banks make their money from interest income alone, though. Some rely heavily on 'other income'. This can include credit card or account fees. Those with big investment banks also earn money for advising on big corporate deals or IPO services, as well as trading commission. A lot of banks also have chunky insurance businesses, so it’s always worth looking at this too.

Banks with alternative income streams can be more resilient in low-interest rate environments because they rely less on traditional lending. By the same token, at times of interest rate hikes, those with higher exposure to loans should do well.

How much is too much cash to have under the mattress?

Banks must keep a certain amount of capital, uninvested, on hand at all times. The minimum level is set by the regulator and is based on a proportion of a bank’s assets. This capital hoard acts as a safety net for customers.

The so called CET1 ratio is how a bank represents its capital levels, and it’s shown as a percentage.

In their results, a bank will usually let you know what the minimum level is required by regulators – and then the board will have its own, usually slightly higher, minimum target. If a bank’s CET1 ratio is much higher than the minimum target, investors should be asking why. After all, too much cash sitting around not doing anything is wasted potential.

A high CET1 ratio can mean a bank is looking to make an acquisition or increase the dividend – or at least that would be the hope. If a financial company doesn’t come out with a plan for the excess capital, it can raise question marks. At best, it’s a bug bear.

What if people can’t repay their loans?

This is ultimately the risk when anyone lends money, doesn’t matter if it’s a banking conglomerate or a family member. They might not get that money back.

Of course, banks have more sophisticated measures in place to lower the risk of that happening. But it still happens.

If a bank thinks more customers than expected are going to default on their loans, they will incur what’s known as an impairment charge. This is a reduction in the value of a company’s assets, and it lowers profits. This happening as a one off isn’t a huge cause for concern and should be seen as a blip. But if a bank repeatedly seems to be misjudging the riskiness of its loans, that can signal a bigger problem.

Don’t bank on getting confused

It can be easy to assume that you wouldn’t know where to start when it comes to knowing how a bank really works. But you shouldn’t bank on getting confused because it’s really not as hard as it sounds.

The important thing to remember is that no two banks are created equal, and the different types of income, loan profiles and capital requirements make for an eclectic mix of potential investments. It’s really worth taking a few minutes to understand a company that you’re thinking of investing in. But if you don’t fancy doing all the heavy lifting yourself, you can use our share research to help with your investment decisions.

Investing in individual companies isn’t right for everyone – it’s higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

All investments can fall as well as rise in value, so you could get back less than you invest. If you’re not sure an investment is right for you, seek advice.

The Switch Your Money On podcast from Hargreaves Lansdown

This podcast isn’t personal advice. If you’re not sure what’s right for you seek advice. Investments rise and fall in value, so investors could make a loss.

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Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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