As a small-cap bank stock with a market capitalisation of US$2.2b, First Merchants Corporation’s (NASDAQ:FRME) risk and profitability are largely determined by the underlying economic growth of the US regions in which it operates. Since banks make money by reinvesting its customers’ deposits in the form of loans, strong economic growth will drive the level of savings deposits and demand for loans, directly impacting the cash flows of those banks. Post-GFC recovery brought about a new set of reforms, Basel III, which was created to improve regulation, supervision and risk management in the financial services industry. The Basel III reforms are aimed at banking regulations to improve financial institutions’ ability to absorb shocks caused by economic stress which could expose banks like First Merchants to vulnerabilities. Since its financial standing can unexpectedly decline in the case of an adverse macro event such as political instability, it is important to understand how prudent the bank is at managing its risk levels. Strong management of leverage and liquidity could place the bank in a protected position at the face of macro headwinds. We can gauge First Merchants’s risk-taking behaviour by analysing three metrics for leverage and liquidity which I will take you through now.
Is FRME’s Leverage Level Appropriate?
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. Though banks are required to have a certain level of buffer to meet its capital requirements, First Merchants’s leverage level of 7.26x is very safe and substantially below the maximum limit 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 increase its debt levels to firm up its capital cushion, there is plenty of headroom to do so without deteriorating its financial position.
How Should We Measure FRME’s Liquidity?
As I eluded to above, loans are relatively illiquid. It’s helpful to understand how much of this illiquid asset makes up First Merchants’s total asset. Generally, they should make up less than 70% of total assets, but its current level of 72% means the bank has lent out 1.94% above the sensible upper limit. This indicates that revenue is dependent on this particular asset but also the bank is more likely to be exposed to default compared to its competitors with less loans.
What is FRME’s Liquidity Discrepancy?
Banks operate by lending out its customers’ deposits as loans and charge a higher interest rate. Loans are generally fixed term which means they cannot be readily realized, conversely, on the liability side, customer deposits must be paid in very short notice and on-demand. The disparity between the immediacy of deposits compared to the illiquid nature of loans puts pressure on the bank’s financial position if an adverse event requires the bank to repay its depositors. Compared to the appropriate industry loan to deposit level of 90%, First Merchants’s ratio of over 93% is higher which positions the bank in a risky spot given the potential to cross into negative liquidity disparity between loan and deposit levels. Essentially, for $1 of deposits with the bank, it lends out more than $0.9 which is risky.
Keep in mind that a stock investment requires research on more than just its operational side. I’ve put together three relevant factors you should further examine:
- Future Outlook: What are well-informed industry analysts predicting for FRME’s future growth? Take a look at our free research report of analyst consensus for FRME’s outlook.
- Valuation: What is FRME worth today? Has the future growth potential already been factored into the price? The intrinsic value infographic in our free research report helps visualize whether FRME is currently mispriced by the market.
- 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.