The Bank of East Asia Limited (SEHK:23) is a large-cap stock operating in the financial services sector with a market cap of HKD HK$90.02B. As major financial institutions return 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. These reforms target bank level regulation and aims to improve the banking sector’s ability to absorb shocks arising from economic stress which could expose financial institutions to vulnerabilities. As a large bank in HK, 23 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. Check out our latest analysis for Bank of East Asia

Why Does 23’s Leverage Matter?

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. Financial institutions are required to have a certain level of buffer to meet capital adequacy levels. Bank of East Asia’s leverage level of 8x is very safe and substantially below the maximum limit of 20x. With assets 8 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.

What Is 23’s Level of Liquidity?

As abovementioned, loans are quite illiquid so it is important to understand how much of these loans make up the bank’s total assets. Usually, they should not be higher than 70% of total assets, which is consistent with Bank of East Asia’s state given its ratio of 60.50%. This means slightly over half of the bank’s total assets are tied up in the form of illiquid loans, leading to a sensible balance between interest income and liquidity.

Does 23 Have Liquidity Mismatch?

Banks operate by lending out its customers’ deposits as loans and charge a higher interest rate. These loans may be fixed term and often cannot be readily realized, conversely, on the liability side, customer deposits must be paid in very short notice and on-demand. 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. Since Bank of East Asia’s loan to deposit ratio of 77.78% is within the sensible margin, below than the appropriate maximum of 90%, this level 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.

Conclusion

Bank of East Asia passes all of our liquidity and leverage checks which shows it is prudent in managing those factors. This gives us confidence in the operational 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 23 in this article. But as a stock investment, there are other fundamentals you need to understand. There are three key factors you should further research:

• 1. Future Outlook: What are well-informed industry analysts predicting for 23’s future growth? Take a look at our free research report of analyst consensus for 23’s outlook.

• 2. Valuation: What is 23 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 23 is currently mispriced by the market.

• 3. 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 pass 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.