Oak Valley Bancorp’s (NASDAQ:OVLY) profitability and risk are largely affected by the underlying economic growth for the region it operates in US given it is a small-cap stock with a market capitalisation of US$147m. Since a bank profits from reinvesting its clients’ deposits in the form of loans, negative economic growth may lower deposit levels and demand for loan, adversely impacting its cash flow. Following the Financial Crisis in 2008, a set of reforms termed Basel III was enforced to bolster risk management, regulation, and supervision in the financial services industry. Basel III target banking regulations to improve the sector’s ability to absorb shocks resulting from economic stress which may expose financial institutions like Oak Valley Bancorp 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 Oak Valley Bancorp’s risk-taking behaviour by analysing three metrics for leverage and liquidity which I will take you through now.
Why Does OVLY’s Leverage Matter?
Banks with low leverage are exposed to lower risks around their ability to repay debt. A bank’s leverage can be thought of as the amount of assets it holds compared to its own shareholders’ funds. Financial institutions are required to have a certain level of buffer to meet capital adequacy levels. Oak Valley Bancorp’s leverage level of less than the suitable maximum level of 20x, at 11.25x, is considered to be very cautious and prudent. This means the bank has a sensibly high level of equity compared to the level of debt it has taken on to maintain operations which places it in a strong position to pay back its debt in unforeseen circumstances. 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 OVLY’s Liquidity?
Since loans are relatively illiquid, we should know how much of the bank’s total assets are comprised of these loans. Generally, they should make up less than 70% of total assets, which is consistent with Oak Valley Bancorp’s state given its ratio of 61%. This is a reasonable ratio and suggests that slightly over half of the bank’s total assets are tied up in the form of illiquid loans, striking an appropriate balance between liquidity and interest income.
What is OVLY’s Liquidity Discrepancy?
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. 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. Since Oak Valley Bancorp’s loan to deposit ratio of 67% is well-below than the appropriate maximum of 90%, this 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.
Oak Valley Bancorp passes all of our liquidity and leverage checks, suggesting it is prudent in managing those factors. This gives us confidence in the risk management side of the business, an important aspect to consider before investing in the stock. High liquidity and low leverage places the bank in an ideal position to repay financial liabilities in case of adverse headwinds. We’ve only touched on operational risks for OVLY in this article. But as a stock investment, there are other fundamentals you need to understand. There are three relevant factors you should further research:
- Future Outlook: What are well-informed industry analysts predicting for OVLY’s future growth? Take a look at our free research report of analyst consensus for OVLY’s outlook.
- Valuation: What is OVLY 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 OVLY 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.
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.