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Introduction to Banks: How Do Banks Differ From Other Companies?

In a previous piece, we talked about how to interpret a bank's balance sheet. We noted that the line items typically found on the balance sheet are somewhat different fromo those usually found in the financial statements of non-bank firms. Here, we discuss the larger, more systemic ways that banks differ from non-financial companies.

Cash flows can fluctuate

Banking cash flows can be highly variable as they are dependent on factors outside the bank's control, such as national interest rates. One of the most important metrics for a bank is its net interest margin (NIM), which is the difference between the interest charged to borrowers and the interest paid out to creditors. Banks borrow short term and lend long term, which means that changes in the interest rate tend to affect borrowing costs more so than lending profits.

The so-called "asset-liability time mismatch" illustrates this point well. If a bank offers a customer a 30-year fixed-rate mortgage, it is essentially locked into that agreement for the next few decades. However, most savers don't hold cash in their accounts for that long, and have the right to demand it back whenever they want. If the interest rate increases, the bank will have to increase the rate that it pays to savers (or else they will take their business to a competitor), but will be handcuffed to the old rate it paid out to the mortgage-holder. For this reason, we say that banks "lend long and borrow short."

The burden of regulation

Depending on your personal persuasions, you may think that banks are either regulated extremely efficiently or extremely inefficiently. However, what is undeniable is that regulation in the financial sector is considerably more complex than that of other industries. There are a number of different types of regulation that banks (and other financial firms) need to follow. They are required to maintain adequate capital ratios so that they are able to absorb unexpected losses from loan delinquencies. They must meet their reserve requirements to prevent a run.

The ability of big banks to consolidate their positions in the market through mergers and acquisitions is also closely scrutinized by regulators -- although you may argue that in recent years this does not happen as much as it should. Finally, banks are also limited by how they can invest their capital. For instance, in many jurisdictions, investment banks are supposed to separate their investment activities from their retail activities.

In the U.S., the Glass-Steagall Act of 1933 put in place such regulation; it gradually declined in importance during the second half of the 20th century and was formally repealed in 1999. It is a common talking point to claim that the repeal of Glass-Steagall is what caused the financial crisis of 2008, but most of the activities that ultimately contributed to the crash did not come under the purview of the act.

These are just some of the things that investors in banks need to be aware of when investing in this sector. Banking regulation is complex and frequently changes the rules of the game, which can make long-term projection difficult. But large banks are typically (though not always) more able to withstand regulatory changes than their smaller competitors.

Disclosure: The author owns no stocks mentioned.

Read more here:

Steve Eisman: Money Today Has Become Free

An Introduction to Banks: The Balance Sheet

How to Build a Discounted Cash Flow Model: Estimating Cost of Capital

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This article first appeared on GuruFocus.