US Banking Industry Analysis | Valuation and Performance | Aranca Articles and Publications

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US Banks:
Fundamentals Ahead of Valuations?
Aranca Views
A Research Note By
Subarna Poddar
January 15, 2015

2
Aranca Views: US Banks – Fundamentals Ahead of the Valuations?
January 2015
US Banks Valuation
01
“Irrational caution” on the part of investors

3
January 2015
0
500
1000
1500
2000
2500
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
S&P Banks Select Industry Index S&P 500 Index
US banking sector underperforming the market over last seven years
S&P Banks Select Industry Index vs. S&P 500 Index
 US banks underperformed the broader
market after the onset of the global economic
crisis in early 2007.
 The S&P Banks Select Industry Index
indicated negative return of 3.65% YoY in the
last 10 years compared with 7.67% YoY by
S&P 500.
 In 2008, banks and financial institutions were
at the center of this crisis and accumulated
huge subprime assets, which led to significant
losses in their books.
 Since 2009, banks have tried to restructure
their balance sheets and operations. Most
banks have almost returned to the pre-crisis
level, although they continue to underperform
the broader market indices.
Source: Bloomberg

4
January 2015
Valuations below pre-crisis level
PB band chart of top 10 US banks
 Banking stocks are trading at a significant
discount to the pre-crisis level valuation.
 While the US banks’ current PB of about 1.0x
is a significant improvement over the low of
0.3x during the economic crisis, it is below the
high of 2.1x during the pre-crisis period.
 The difference in valuation is despite an
improvement in bank earnings to the pre-
crisis level.
Source: Bloomberg
0.9x
0.3x
1.5x
2.1x
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Jan-04
May-04
Sep-04
Jan-05
May-05
Sep-05
Jan-06
May-06
Oct-06
Feb-07
Jun-07
Oct-07
Feb-08
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Oct-08
Feb-09
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Oct-09
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Mar-11
Jul-11
Nov-11
Mar-12
Jul-12
Nov-12
Apr-13
Aug-13
Dec-13
Apr-14
Aug-14
Dec-14
NetProfit(millions)
Following are the top 10 banks we used for analysis:
1.Barclays Group US, Inc.(BCS US)
2. Bank of America Corp. (BAC US)
3. Bank of New York Mellon Corp. (BK US)
4. Citigroup Inc. (C US)
5. Goldman Sachs Group, Inc. (GS US)
6. HSBC North American Holdings Inc. (HSBC US)
7. JPMorgan Chase & Co. (JPM US)
8. Morgan Stanley (MS US)
9. US Bancorp (USB US)
10. Wells Fargo & Co. (WFC US)

5
January 2015
Current valuation appearing to suggest “irrational caution” on the part of investors
PB/RoE scatter chart of top US banks in 2007 vis-à-vis 2014
 A comparison between the 2007 and 2014
PB/RoE ratios of the top US banks indicates
the RoE of the banks has not reached the
pre-crisis level.
 Book value of the banks rose in the last two
years, as the banks increased their equity
base to comply with BASEL III norms, leading
to a fall in PB.
*Bubble size denotes Market Cap
Source: Company filings, Bloomberg
JPM
C
GS
USB
BAC
WFC
MS BK
-5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
0.0x 0.5x 1.0x 1.5x 2.0x 2.5x 3.0x 3.5x
2007RoE 2007 PB
JPM
C
GS
USB
BAC
WFC
MS
BK
-5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
0.0x 0.5x 1.0x 1.5x 2.0x 2.5x 3.0x 3.5x
CurrentRoE
Current PB

6
January 2015
Operational Performance
02
Operational improvements to warrant re-rating?

7
January 2015
Is valuation pertinent given improvement in banking operations?
Operating margin of top US banks
 In recent years, US banks’ revenues have
risen above the pre-crisis levels due to high
net interest income, trading income,
investment banking, asset management, and
fee income.
 With regard to efficiency, US banks managed
to keep the cost-to-income ratio below 60%.
 Operating margin improved considerably, but
is yet to reach the pre-crisis bars.
-40%
-20%
0%
20%
40%
60%
80%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
BCS US BAC US BK US C US GS US
HSBC US JPM US MS US USB US WFC US

8
January 2015
Improvement in bottom line on low provisions
Net profit margin of top US banks
 US banks’ earnings are growing as
improvement in asset quality and writing off
bad loans is leading to low provisions
 The bottom line improved majorly due to a
decline in loan loss provisions, which reduced
to 4.4% of the total revenue of the top 10 US
banks in 2013 from 28.3% in 2008.
 The average ROE of US banks trended
upward after 2009 to 7.7% in 2013 from just
0.3% in 2008. However, it has not touched
the 2007 level of 11.9%.
-80%
-60%
-40%
-20%
0%
20%
40%
60%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

9
January 2015
NIM consistently below pre-crisis level with sustained deterioration
Net interest margin of top US banks
 The declining NIM barely supported
revenues, whereas capital gains, as a % of
total revenue, increased.
 NIM remained much below the pre-crisis level
due to ultra-low FED rates.
 The end of QE would lead to a rise in US
interest rates, which would help improve the
NIM of US banks.
-1%
0%
1%
2%
3%
4%
5%
6%
7%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

10
January 2015
Trading income rises with rebound in stock markets
Capital gains as a % of total revenue
 Trading income rose considerably with
improvement in the stock market and high
proprietary trading.
 High trading income (although substantially
low as a % of total income) is susceptible to a
downturn in the stock market.
Source: Company filings
-20.0% -10.0% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0%
BCS US
BAC US
BK US
C US
GS US
HSBC US
JPM US
MS US
USB US
WFC US
2013 2007

11
January 2015
Gradual improvement in lending growth
Lending growth of top US banks
 Lending activity remained the key driver of
growth in interest income. Low FED rates
were not conducive for the NIM environment
of US banks.
 Loans of the top 10 US banks increased at a
CAGR of 12.8% from 2004–07 compared with
2.3% from 2007–13.
-100%
-50%
0%
50%
100%
150%
200%
2005 2006 2007 2008 2009 2010 2011 2012 2013

12
January 2015
Lending growth in different sectors supported by US economic upturn
Commercial loans grew significantly on high private investments
 Improvement in the US economy supported
the overall growth of the banking industry.
 With advancement in public spending, the
real estate loan segment experienced stable
growth.
 Increasing economic activities added to the
loan growth in private sectors, leading to a
boom in the commercial loan segment.
 Loans to non-financial corporations grew
more than 5%.
 Despite improvement in consumer sentiment,
consumer lending remained below the pre-
crisis levels due to corporate and household
de-leveraging.
-20.0%
-10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
2005 2006 2007 2008 2009 2010 2011 2012 2013
Real Estate Loans Commercial Loans Consumer Loans

13
January 2015
Decline in non-performing loans compared with those in pre-crisis level
Non-performing loans and coverage ratios of US banks
 Non-performing loans (NPLs) declined
compared with those in the pre-crisis level.
 The average non-performing asset (NPA)
level of the top 10 US banks fell to 2.2% in
2013 from 4.1% in 2009.
 The coverage ratio of the top US banks
deteriorated consistently from 133% in 2004
to 85% in 2013. This highlights the extent of
under-provisioning to cushion profitability.
0%
20%
40%
60%
80%
100%
120%
140%
160%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
NPL % Coverage Ratio (%)

14
January 2015
Lending growth supported by stable rise in deposits
Deposit growth of top US banks
 The per capita and disposable incomes of US
citizens increased, driven by an increase in
job creation. This supported the deposit
growth.
 Loan growth was majorly funded by high
deposits. The CAGR of US banking deposits
stood at 9.1% from 2004–13, driven by high
disposable incomes of US citizens. Loans
increased at a CAGR of 5.7% during the
same period.
 The combined loan-to-deposit (LTD) ratio
reduced to 71% in 2013 from 94% in 2004, as
banks restricted lending to risky portfolios and
implemented strict KYC norms.
 The liquidity of banks improved with the LTD
ratio coming down significantly.
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
120%
140%
2005 2006 2007 2008 2009 2010 2011 2012 2013

15
January 2015
Regulatory Measures
03
Eliminating risk factors

16
January 2015
Introduction of regulatory measures to strengthen US banking system
Market
Stabilization
 During the 2007–10 financial crisis, the lack of transparency in the market became
a concern for regulators; hence, the US FED decided to intervene directly in
financial markets to reduce volatility and stabilize prices.
 Key financial reforms include removing risky assets from banks’ balance sheets and
raising more long-term sustainable capital. The BASEL III guidelines introduced the
concept of core Tier 1 equity capital, capital conservation buffer, and counter
cyclical buffer to cope with severe downturn and risk of failure.
BASEL III
 The Dodd Frank Act was formed to create a sound economic foundation to increase
jobs, protect consumers, rein in Wall Street and big bonuses, end bailouts and “Too
Big to Fail,” and prevent another financial crisis.
Dodd Frank Act
 The Volcker rule was introduced to limit banks’ speculative trading activities, restrict
proprietary trading, and regulate derivatives to reduce risk taking.
Volcker Rule
Strong banking
supervision

17
January 2015
Most top US banks are way above their BASEL III regulatory requirements
Basel III Compliance – US Banking Sector
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
WFC USB MS JPM HSBC GS C BK BCS BAC
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
0%
2%
4%
6%
8%
10%
12%
JPM BAC C WFC GS MS BCS BK USB HSBC
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
Tangible Common Equity Ratio
Total Risk-Based Capital Ratio
Tier 1 Risk-Based Capital Ratio
Tier 1 Leverage Ratio
Regulatory
requirement as
per BASEL III Regulatory
requirement as
per BASEL III
Regulatory
requirement as
per BASEL III
Regulatory
requirement as
per BASEL III

18
January 2015
CAMEL analysis of top US banks indicating GS performed better than peers in maintaining high level
of capital adequacy
Capital Adequacy Ratios (2013)
Source: Bloomberg, Aranca Analysis
0%
5%
10%
15%
20%
WFC
USB
MS
JPM
HSBC
GS
C
BK
BCS
BAC
0%
5%
10%
15%
20%
WFC
USB
MS
JPM
HSBC
GS
C
BK
BCS
BAC
0%
3%
6%
9%
12%
WFC
USB
MS
JPM
HSBC
GS
C
BK
BCS
BAC
0%
5%
10%
15%
20%
WFC
USB
MS
JPM
HSBC
GS
C
BK
BCS
BAC
Tier 1 Risk-Based
Capital Ratio
Tangible
Common Equity
Ratio
Total Risk-Based
Capital Ratio
Tangible
Common Equity
to Risk-Weighted
Assets
C A M E L

19
January 2015
BK better placed among peers in terms of asset quality, with low NPL level; HSBC underperforming
with high NPLs and low coverage ratio
Asset Quality Ratios (2013)
Non-performing
Loans (NPLs)/
Total Loans
Coverage Ratio
Provisions/Net
Revenue
Cost of Risk (bps)
C A M E L
0%
1%
2%
3%
4%
WFC
USB
JPM
HSBC
C
BK
BCS
BAC
-4%
0%
4%
8%
12%
WFC
USB
JPM
HSBC
C
BK
BCS
BAC
0%
50%
100%
150%
200%
250%
WFC
USB
JPM
HSBC
C
BK
BCS
BAC
-30
0
30
60
90
120
WFC
USB
JPM
HSBC
C
BK
BCS
BAC

20
January 2015
Increase in headcount of GS in 2013; significant growth in sales and net income per employee
Management Quality Ratios (2013)
Actual Sales Per
Employee (USD
‘000)
Net Income/
Employee
(USD ‘000)
YoY growth in
Headcount
Efficiency Ratio
C A M E L
0
400
800
1,200
1,600
WFC
USB
MS
JPM
HSBC
GS
C
BK
BCS
BAC
-12%
-8%
-4%
0%
4%
WFC
USB
MS
JPM
HSBC
GS
C
BK
BCS
BAC
0
50
100
150
200
250
WFC
USB
MS
JPM
HSBC
GS
C
BK
BCS
BAC
0%
20%
40%
60%
80%
100%
WFC
USB
MS
JPM
HSBC
GS
C
BK
BCS
BAC

21
January 2015
WFC and USB relatively superior in converting assets to earnings; poor performance by BCS
Earnings Ability Ratios (2013)
Return on
(Average) Equity
Pre-tax Margin
Return on
(Average) Assets
Operating Margin
C A M E L
0%
5%
10%
15%
20%
WFC
USB
MS
JPM
HSBC
GS
C
BK
BCS
BAC
0.0%
0.5%
1.0%
1.5%
2.0%
WFC
USB
MS
JPM
HSBC
GS
C
BK
BCS
BAC
0%
10%
20%
30%
40%
50%
WFC
USB
MS
JPM
HSBC
GS
C
BK
BCS
BAC
0%
10%
20%
30%
40%
50%
WFC
USB
MS
JPM
HSBC
GS
C
BK
BCS
BAC

22
January 2015
BCS among most aggressive lenders in peer group; BAC and JPM with highest short-term deposits
in their books
Liquidity Ratios (2013)
Loan-to-Deposit
Ratio
Short-Term
Deposits/Total
Deposits
Customer
Deposits/Total
Assets
Deposit Growth
C A M E L
0%
30%
60%
90%
120%
WFC
USB
MS
JPM
HSBC
GS
C
BK
BCS
BAC
0%
20%
40%
60%
80%
WFC
USB
MS
JPM
HSBC
GS
C
BK
BCS
BAC
0%
20%
40%
60%
80%
100%
WFC
USB
JPM
HSBCBK
BCS
BAC
-5%
5%
15%
25%
35%
JPM
BAC
C
WFC
GS
MS
BCS
BK
USB
HSBC

23
January 2015
Conclusion
04
Fundamentals ahead of valuations

24
January 2015
Fundamentals ahead of valuations; upside expected
Sector requires
re-rating
Sound
Fundamentals
 After analyzing the fundamentals and valuations of big banks simultaneously, it can
be concluded that US banks have strengthened fundamentally over the last six
years. Loan and deposit growth improved from an almost bottomed-out scenario in
2008; operating metrics such as net interest income, fee income, and operating
income increased, but the NPL level reduced. Although NIM is below the pre-crisis
level, it is expected to improve with the hike in FED rates.
 Although the stringent regulatory guidelines impacted the operating maneuverability
and limited the trading gains of banks, banks can operate under relatively strict
supervision to avert another crisis. The emphasis on the quality and quantity of
capital requirement is another effort to build relatively more robust banks to face an
economic downturn.
Regulatory
Compliance
 In the current scenario, while US banks regained some lost ground, they appear to
be undervalued and have reasonable upside potential.
 Yet, investors would do well to keep a close watch on evolving global economic
scenario, exposure to problematic regions and any rate decision by the FED.
Rate Hike, Key
Event to Watch
for

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