As a small-cap finance stock with a market capitalisation of UK£179m, the risk and profitability of Arbuthnot Banking Group PLC (LON:ARBB) are largely tied to the underlying economic growth of the region it operates in GB. Given that banks operate by reinvesting deposits in the form of loans, negative economic growth may lower the level of saving deposits and demand for loans, directly affecting those banks’ levels of cash flows. After the GFC, a set of reforms called Basel III was imposed in order to strengthen regulation, supervision and risk management in the banking sector. These reforms target banking regulations and intends to enhance financial institutions’ ability to absorb shocks resulting from economic stress which could expose banks like Arbuthnot Banking Group to vulnerabilities. Its financial position may weaken in an adverse macro event such as political instability which is why it is crucial to understand how well the bank manages its risks. Low levels of leverage coupled with sufficient liquidity may place Arbuthnot Banking Group in a safe position in the face of adverse headwinds. We can measure this risk exposure by analysing three metrics for leverage and liquidity which I will take you through today.
Why Does ARBB’s Leverage Matter?
A low level of leverage subjects a bank to less risk and enhances its ability to pay back its debtors. Leverage can be thought of as the amount of assets a bank owns relative to its shareholders’ funds. Financial institutions are required to have a certain level of buffer to meet capital adequacy levels. Arbuthnot Banking Group’s leverage level of 8.69x is significantly below the appropriate ceiling of 20x. This means the bank exhibits very strong leverage management and is well-positioned to repay its debtors in the case of any adverse events since it has an appropriately high level of equity relative to the debt it has taken on to remain in business. If the bank needs to firm up its capital cushion, it has ample headroom to increase its debt level without deteriorating its financial position.
What Is ARBB’s Level of Liquidity?
As I eluded to above, loans are relatively illiquid. It’s helpful to understand how much of this illiquid asset makes up the bank’s total asset. Normally, they should not exceed 70% of total assets, consistent with Arbuthnot Banking Group’s case with a ratio of 54%. At this level of loan, the bank has preserved a sensible level between maintaining liquidity and generating interest income from the loan.
Does ARBB Have Liquidity Mismatch?
Banks operate by lending out its customers’ deposits as loans and charge a higher interest rate. These loans tend to be fixed term which means they cannot be readily realized, yet customer deposits on the liability side must be paid on-demand and in short notice. This mismatch between illiquid loans and liquid deposits poses a risk for the bank if unusual events occur and requires it to immediately repay its depositors. Compared to the appropriate industry loan to deposit level of 90%, Arbuthnot Banking Group’s ratio of over 62% is noticeably lower, which means the bank is lending out less than its total level of deposits and places the bank in a relatively safe liquidity position given it has not excessively lent out its deposits and has maintained a suitable level for compliance. Given the large headroom for growth in loans, the bank has opportunity to grow its interest income.
Arbuthnot Banking Group meets all of our liquidity and leverage criteria, exhibiting operational prudency. The operational risk side of a bank is an important fundamental often overlooked by investors. The bank’s favourable liquidity and leverage position exposes it to less risk when it comes to repaying financial obligations, in particular, in the case of an adverse macro event. We’ve only touched on operational risks for ARBB in this article. But as a stock investment, there are other fundamentals you need to understand. There are three pertinent factors you should further research:
- Future Outlook: What are well-informed industry analysts predicting for ARBB’s future growth? Take a look at our free research report of analyst consensus for ARBB’s outlook.
- Historical Performance: What has ARBB’s returns been like over the past? Go into more detail in the past track record analysis and take a look at the free visual representations of our analysis for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.