As a large-cap stock with market capitalization of GBP $69.29B, Lloyds Banking Group plc (NYSE:LYG) is classified as a major bank. As these large financial institutions revert back to health after the Global Financial Crisis, we are seeing an increase in market confidence, and understanding of, these “too-big-to-fail” banking stocks. After the crisis, a set of reforms called Basel III was created with the purpose of strengthening regulation, risk management and supervision in the banking sector. Basel III target banking regulations to improve the sector’s ability to absorb shocks resulting from economic stress which may expose financial institutions like banks to vulnerabilities. As a large bank in US, LYG is exposed to strict regulation which has focused investor attention on the type and level of risks it is subjected to, and higher scrutiny on its risk-taking behaviour. We should we cautious when it comes to investing in financial stocks due to the various risks large banks tend to face. Today we will analyse some bank-specific metrics and take a closer look at leverage and liquidity. View our latest analysis for Lloyds Banking Group
Is LYG’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. While financial companies will always have some leverage for a sufficient capital buffer, Lloyds Banking Group’s leverage ratio of 16x is very safe and substantially below the maximum limit of 20x. 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.What Is LYG’s Level of Liquidity?
As I eluded to above, loans are relatively illiquid. It’s helpful to understand how much of this illiquid asset makes up the bank’s total asset. Normally, they should not exceed 70% of total assets, consistent with Lloyds Banking Group’s case with a ratio of 57.49%. At this level of loan, the bank has preserved a sensible level between maintaining liquidity and generating interest income from the loan. Does LYG Have Liquidity Mismatch?
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, 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 Lloyds Banking Group’s loan to deposit ratio of 105.47% is higher than the appropriate level of 90%, this level puts the bank in a risky position due to the negative liquidity disparity between loan and deposit levels. Basically, for GBP 1 of deposits with the bank, it lends out over GBP 1 which is imprudent.Final words
The bank’s prudent management of its risk levels is reflected in its sensible leverage and liquidity ratios. This means it is well-positioned to meet its financial obligations in case of any unforeseen and adverse macro events.
Now that you know to keep in mind these liquidity factors when putting together your investment thesis, I recommend you check out our latest free analysis report on Lloyds Banking Group to see its growth prospects and whether it could be considered an undervalued opportunity.
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