Why I avoid investing in banks

The Quality Shares Portfolio doesn’t hold any bank shares. Nor do I envisage this changing any time soon. 

Why? The vast majority of banks have impenetrable accounting, in my opinion, and I simply don’t understand them. And even if I did, I still wouldn’t invest, because they don’t meet my strict quality criteria. 

Banking is an extremely competitive industry that relies almost entirely on perception and belief. The business model only works if depositors have faith their deposits are secure. Once that faith erodes – irrespective of how founded the fears are – you are in real trouble.

The risks of investing in banks are further magnified by leverage. Banks rely on a very small amount of equity to fund their assets. This means a small decrease in assets can potentially wipe out most or all of the equity. If a few loans go bad, or you get your sums wrong, the consequences can be disastrous.

To compound matters, a lot of banks have a mismatch between their assets and liabilities. 

A simple explanation

Imagine you have £1,000 in an instant access account at ‘Bank of Charlie’. I decide to keep that deposit as cash. A year later, you ask for your cash back and I wire you the money. The only problem is, I’ve made little or no return on that cash and shareholders of Bank of Charlie aren’t amused by the measly profits.

Imagine now if I took your deposit and invested it in a 10-year government bond. By locking the money away, I can earn higher interest and higher profits. But there’s a catch. A year later, you decide you want your cash back. The 10-year bonds I bought are now only worth £800, because interest rates have risen. When I sell these bonds (assuming I can), I’m faced with a £200 shortfall. 

This was the main issue behind the recent failure of Silicon Valley Bank. It invested deposits, which could be withdrawn any time, in long-term debt. As interest rates rose, the value of those debt instruments fell, creating a liquidity crunch when multiple depositors asked for their money back at the same time. Widespread fear did the rest. 

Picking up pennies in front of a steamroller

What’s more, despite the risks, most banks make modest returns. In the good times, they are picking up pennies in front of a steamroller. In a crisis, they can easily be wiped out. In my view, the returns simply aren’t worth the risk.

And I believe the returns banks earn are likely to get worse from here, not better.

Banks are integral to the economy, so regulators scrutinise them closely. Regulations have become more onerous since the 2008/09 financial crisis. This latest debacle is only likely to exacerbate that trend, making it even harder for banks to earn decent returns.   

Put all that together and 99.9% of banks are uninvestable for me, no matter how ‘cheap’ their shares appear to be. Call me boring, but I’d much rather invest in resilient, simple-to-understand businesses that are strengthened by a crisis, rather than hobbled by it.