Chapter 02 · How sectors differ
Banks and the credit cycle
A bank earns the gap between what it pays for money and what it charges to lend, after the loans that are not repaid. This chapter follows that sentence through a cycle so a single good quarter does not look like a personality.
The spread is the business
Deposits and borrowings have a cost. Loans and investments have a yield. The difference, after operating costs, is the raw material of profit, and then credit cost takes a bite. A bank can widen the reported gap for a while by lending to riskier borrowers who pay more. The cost of that decision arrives later, as provisions, when the borrowers fail. A year of fat margins and tiny provisions is not the opposite of a year of heavy provisions. It is often the earlier chapter of the same story.
Credit cost is delayed, which is why the cycle fools people
A loan does not become a non-performing asset the week the borrower’s business turns down. It passes through a clock defined by the regulator: overdue for a stated period, then recognised, then provided for. The share price often reacts when the recognition happens, not when the factory first went quiet. If you only look at the quarter provisions fell, you are looking at the accounting clock. Ask what grew two and three years earlier. A surge in unsecured retail loans, or in lending to a single industry, is the place to mark in the margin, even while the current provisions still look calm.
A sketch of one cycle
| Phase | What the statements tend to show | What people say | The dull reading |
|---|---|---|---|
| Expansion | Loan growth high, provisions low, profits rising | The management is excellent. | The book has not seasoned yet. |
| Recognition | Provisions jump, profit falls, growth slows | The management has lost its touch. | The earlier growth is being priced, late. |
| Repair | Growth stays dull, provisions ease, capital is raised | Nothing is happening. | The balance sheet is being made usable again. |
The labels are a sketch, not a calendar you can trade. Banks do not move together perfectly. A bank that stuck to borrowers with steady cash flows will look boring in the expansion and look like a genius in the recognition, when it was the same bank all along. Compare provision coverage, capital adequacy, and the mix of the loan book, not the latest profit growth.
Numbers that belong on one page
- The loan mix: retail, small business, corporate, and how much is unsecured.
- Gross bad loans, and provisions as a fraction of those bad loans. A low provision against a large bad book is a future profit that has already been promised away.
- Capital adequacy, so you know whether the next bad year can be absorbed without a desperate share issue.
- The cost of funds moving faster or slower than the yield on loans. In a rising-rate year these two do not update on the same day.
- Related-party lending and concentration in a handful of groups, from the notes.
What to remember
- A bank’s profit is the lending spread minus credit costs that arrive on a delay.
- Low provisions during fast growth are not a permanent feature of the management.
- Read the loan mix and the provision cover, not only the quarterly profit.
- Capital is what lets a bank survive the recognition phase without issuing shares at the worst time.
- Peers differ by the book they built, not by the slogan in the same quarter’s headline.