Matt Connolly's Blog

my brain dumps here…

Why invest in Banks?

Some time ago, I had an interesting thought about the value of banks – and whether or not we should invest in them.

Banks loan money to people. They provide all sorts of credit: home loans, personal loans, credit cards, etc.

Many banks are listed on the stock exchange – so what are their shares really worth?

Two ways of valuing a business are their assets and their income:

ASSET: A bank’s asset is the money they lend you. On your balance sheet, it’s a liability, on the bank’s balance sheet, it’s an asset. Paying off debt reduces a bank’s assets.

INCOME: A bank’s income is the interest they charge you on credit. On your profit and loss statement, interest charged from a loan is an expense; on their profit and loss statement, it’s income. Paying off debt reduces a bank’s income.

It seems that one of the major factors in the world’s current financial crisis is bad debt.

Let’s consider the possibility of people paying off their debts. Firstly, why would people want to pay off debt?

  • So you can eventually own your own home.
  • To reduce interest payments every month and free up cash flow
  • Gain financial independence
  • Prepare for retirement
  • Be a conservative investor without the risk of suffering from margin calls
  • and, I’m sure there are plenty of other good reasons, too…

Secondly, what would happen if people actually paid off their debts?

You would reasonably expect the banks to lose share value since the act of reducing debt reduces both asset and income for the bank.

So when you invest in bank shares, what are you really investing in? DEBT. Yet people believe that bank shares are a safe investment – safer than biotech, IT, mining or many other industries….

I hope this triggers some thoughtful comments and discussion….

One response to “Why invest in Banks?

  1. Young Ben Bowyang 20 March, 2009 at 10:48

    Hey why is it that banks will loan you up to 110% of the value of your home but only about 50% of the value of shares in themselves….they must consider themselves a greater risk!

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