As a small-cap finance stock with a market capitalisation of US$2.38b, the risk and profitability of First Merchants Corporation (NASDAQ:FRME) are largely tied to the underlying economic growth of the region it operates in US. 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. After the Financial Crisis in 2008, 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 First Merchants to vulnerabilities. Unpredictable macro events such as political instability could weaken its financial position which is why it is important to understand how well the bank manages its risk levels. High liquidity and low leverage could position First Merchants favourably at the face of macro headwinds. A way to measure this risk is to look at three leverage and liquidity metrics which I will take you through today.
Is FRME’s Leverage Level Appropriate?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. While financial companies will always have some leverage for a sufficient capital buffer, First Merchants’s leverage ratio of 7.26x is very safe and substantially below the maximum limit of 20x. With assets 7.26 times equity, the banks has maintained a prudent level of its own fund relative to borrowed fund which places it in a strong position to pay back its debt in times of adverse events. 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 abovementioned, loans are quite illiquid so it is important to understand how much of these loans make up First Merchants’s total assets. Normally, they should not exceed 70% of total assets, however its current level of 71.94% means the bank has lent out 1.94% above the sensible threshold. This means its revenue is reliant on these specific assets which means the bank is also more exposed to defaulting relative to banks with less loans.
What is FRME’s Liquidity Discrepancy?A way banks make money is by lending out its deposits as loans. These loans may be fixed term and often cannot be readily realized, yet customer deposits on the liability side must be paid on-demand and in short notice. This mismatch between illiquid loans and liquid deposits poses a risk for the bank if unusual events occur and requires it to immediately repay its depositors. Relative to the prudent industry loan to deposit level of 90%, First Merchants’s ratio of over 93.33% 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.
We’ve only touched on operational risks for FRME in this article. But as a stock investment, there are other fundamentals you need to understand. There are three relevant aspects you should look at:
- 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 firstname.lastname@example.org.