Banking, at its simplest, is about matching two groups of people: savers who want to keep their cash in a place that is safe and can earn some interest over the long term, and borrowers who need cash to fund projects or purchases now.

Click here to understand more about the background and business models in banking. 

6 steps to investing in banking

1. Consider the banks’ defensiveness

A protective moat is one that defends a company against competition. The banking sector as a whole benefits from several moat-like characteristics.

A. Trustworthiness. Almost everyone trusts banks to look after their money – a fact made easier by the Financial Services Compensation Scheme’s protection of deposits on up to £85,000 per account.

B. Scale. The job of obtaining a banking licence and building a compliance function requires enormous investment. Larger banks’ access to cheaper wholesale funding provides another major advantage.

C. Tight regulation. There are sizeable obstacles for newcomers to vault.

However, what the largest banks lack are truly differentiated product offerings. It is hard to make the case that any one bank has a true competitive edge, particularly in the largely commoditised world of retail banking.

2. Understand the sector’s cycle

Banks (by their nature) are very exposed to the economic cycle – the propensity of businesses and individuals to spend, take on debt or save. This undermines the sector’s defensive qualities – we might use our bank accounts more than any other product, but this is of little use to a bank if people aren’t spending because of recession.

3. Assess operational gearing

Operational gearing is a measure of how revenue growth translates into growth in operating profit.

Banks have plenty of ongoing costs that are necessary to keep them going – staffed branches, City headquarters with salaries to match and legal fees, for example. This means that the sector is highly operationally geared.

High operational gearing makes it difficult to turn revenue into profits. This is especially problematic for the banking sector as income (from borrowers’ interest) has fallen dramatically recently. When that happens the best hope for improving profits is to slash costs which, in turn, lowers the cost-to-income ratio.

4. Assess profitability

Not very is the short answer, at least for the largest UK lenders.

Banks struggle to generate decent returns on equity or on assets (both commonly used measure of profitability) – in other words, profits are low compared with either the total assets or the total equity (assets minus liabilities) on the balance sheet. NatWest, formerly known as Royal Bank of Scotland, has been perhaps the poster child in this regard (see chart).

It’s not all bleak, however. Lenders such as OneSavings Bank (OSB) and Paragon (PAG) have managed to keep their returns on equity at respectable levels, thanks to leaner cost profiles and by pursuing smaller (if more profitable) lending markets – in their case, mortgages for professional landlords.

5. How capital intensive is the sector?

In theory, a bank should start to see a return soon after it makes a loan, meaning it requires fewer upfront costs and could be less capital intensive than housebuilding or mining.

But banks are forced to set aside cash buffers to ensure they can withstand financial shocks. This cash can’t be used and therefore makes the banking sector highly capital intensive.

6. How indebted is the sector?

Banks carry a lot of debt. But this is part of how they function and is not normally a cause for concern as they can borrow much more cheaply than other companies.

How to value the banking sector

The go-to metric for banks stocks is:

P/NAV – a company’s market capitalisation divided by the net asset value (assets minus liabilities)

P/B – a company’s market capitalisation divided by book value (roughly, total assets minus intangible assets)

On this measure, most UK bank stocks appear good value as their market capitalisations are well below their assets. But this is explained by the sector’s difficultly in generating profits: if the banks returns were higher, we might expect their share prices to trade nearer what their balance sheets say they are worth. That banks are valued below their book values suggests that investors do not believe the sector’s future returns can meet their long-term expectations – which given the profound uncertainties that lie ahead should not be a great surprise.