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John from valuestockinquisition.com left a great comment here, and I thought I’d set down some thoughts here with a blog post rather than a comment:

I’m not too worried about EIIB (EIIB:LN) in this context, at this point I pretty much consider it to be a failed bank experiment. Now, they just need to monetize their bank licence and move on. More generally, John has some great points and examples, and I’m sure he could provide more. It’s like fingers in the dyke – for every bank ratio you focus on, there’s another you’re forgetting and that’s about ready to spring a leak. And he highlights that no ratio’s proven to be a reliable predictor of success or failure. God, all in all, just look at any specific TBTF bank and it really just looks like one great bastard of a Rube Goldberg contraption…

Then again, one ratio saved my ass: I was dealing with a lot of (smaller) bank CEO & CFOs just as the credit crunch was looming. Nice guys, all genuine 3-6-3 bankers. Thanks to them, my woeful banking savvy became a little more respectable. I even learned about the wonderfully named Texas Ratio. But one ratio kept coming up, the Loan-to-Deposit Ratio, which they all considered should be within an 80%-120% range. Any banker at 80%, or lower, wasn’t working hard enough, while they were pretty sniffy about competitors towards the top end of the range. And banks above 120% weren’t even worth talking about…

I then diligently calculated Loan-to-Deposit Ratios for Allied Irish Banks (ALBK:ID) and Bank of Ireland (BKIR:ID), and was shocked to find they were at 157% and 174%, respectively! And it seemed like nobody was even batting an eye at these ratios. How could these be right, surely this was a recipe for disaster?! I stared at Irish bank financials for weeks, wondering what I was missing. In the end, I couldn’t get comfortable and sold out of a decent sized B/I stake. And no, I didn’t see what was coming at all… Only for this sale, I suspect I might otherwise have bought the Irish banks all the way down, like a happy value investing fool. I try to control these urges a little better these days…

Actually, I was surprised to see B/I with the higher ratio, I always considered AIB to be its slightly spivvy cousin. Don’t you remember the ICI debacle, their FX scandals (yes, there were actually two), at least two tax scandals (Faldor, DIRT, etc.), and of course the little matter of their 99.8% nationalization?

Aside from the black-box nature of the banking system, the other big problem is that banks are inevitably a leveraged bet on the economy. I used to think this was a good thing. Of course, I also thought that buying company stock and stuffing most of my portfolio with Irish shares was a good thing too. I’ve since realized these present the same asymmetric risk as banks. If things are going gangbusters for your company, for example, who cares if you miss out on some company stock gains? You’re sure to be doing well anyway on the rest of your portfolio, your salary, your job prospects etc. On the other hand, if you own company stock and things go horribly wrong, what’s the end result? ‘Congratulations, you’re fired. Oh, and by the way, your stock’s now pretty much worthless, and the job market sucks..!’.

God, who needs this type of extra/hidden risk in their portfolio? Especially retail investors, who really don’t stand a chance in this regard. Banks are far too complicated and toxic for uninformed investors to invest in on an individual stock basis. I’ve mentioned before that investment funds are probably the best solution for many investors. But even here, they can get screwed in the end. One risk is that their domestic stock market’s naturally ‘bank-heavy’. For example, with the recent 30% TRY decline, I’m pretty keen on Turkey and thought the iShares Turkey ETF (TUR:US) looked a good bet. Until I discovered that 50% of the fund was in Financials…

The other version of this risk is that the weighting of banks in a passive fund will likely swell and peak just before a crash. Actively managed funds are not much better, it seems like most managers end up falling in love with bank stocks at just the wrong time. And I don’t just mean growth funds, the value guys just can’t seem to help themselves when fat Financial yields are dangled in front of them!

Of course, there are always bank stock opportunities out there, and some very smart investors to exploit them, like Wilbur Ross. But for most of us, like trying to time/trade the market, just don’t do it…EVER! I’m serious, I resolved some years to avoid banks permanently, and I urge you to do the same. What will you be missing out on? I’m confident a bank free portfolio will perform equally as well, or better, in the long term as a bank infected portfolio. What’s your opinion? I’m sure there is a study out there on this, if anybody cares to share? Anyway, with Dodd-Frank, Basel III and more to come, a lot of people are now speculating that banks may be ultimately forced into utility-like performance and returns.

I’m dubious of a lot of the new ETFs. With every launch, they’re becoming more obscure, and more synthetic. But I’ve recently noticed some Ex-Financial fund launches – the WisdomTree ETF (DOO:US) is a typical example – and I’m sure we’ll see more of them. These funds seek to cap/haircut, or even better eliminate, their weighting of banks (and other financial stocks). This could prove a rewarding trend, and I believe offers a valuable financial ‘innovation’ and portfolio building block for most investors.

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