Financial Institutions Primer

The Financial Institutions sector is the circulatory system of the economy. It is a highly regulated, leveraged industry encompassing banks, insurance companies, and asset managers, all of which are highly sensitive to economic cycles, interest rate changes, and investor confidence.

📖 Industry Overview

Banks (Depository Institutions)

The core of the financial system, banks take deposits and make loans, profiting from the spread.

  • Business Model: Profit from the Net Interest Margin (NIM) - the spread between the interest earned on loans and the interest paid on deposits. They also earn fee income from services.
  • Players: Global Systemically Important Banks (G-SIBs) like JPMorgan Chase & Bank of America, and thousands of regional and community banks.

Insurance Companies

Insurers manage risk by pooling it among a large number of policyholders.

  • Business Model: Collect premiums, invest this "float" to generate investment income, and pay out claims. Profit comes from both underwriting (premiums > claims/expenses) and investment returns.
  • Players: Berkshire Hathaway (Geico), Progressive (P&C), MetLife (Life).

Asset Managers & Others

This group includes firms that manage investments and facilitate market activity.

📈 Long-Term Trends
  • Post-Crisis Regulation: Since 2008, banks have faced much stricter capital and liquidity requirements (e.g., Basel III, Dodd-Frank Act), making the system safer but potentially less profitable and shifting risk to less-regulated non-bank lenders.
  • FinTech Disruption: Technology is reshaping the industry, from payment apps (Stripe, Block) to online lenders and robo-advisors. Traditional firms are racing to adapt by investing heavily in technology.
  • Interest Rate Environment: The move away from a zero-interest-rate policy (ZIRP) has been a major tailwind for bank profitability (higher NIMs), but a headwind for insurers' existing fixed-income investment portfolios (unrealized losses).
📊 Key Credit Metrics

Metrics are highly specific to each sub-sector. For a detailed comparison, see the deep dive page.

Metric Sub-Sector Description & Importance
CET1 Ratio Banks Common Equity Tier 1. The most important measure of a bank's loss-absorbing capital. A key regulatory focus that determines capacity for growth and shareholder returns.
Net Charge-Offs (NCOs) Banks The percentage of loans written off as uncollectible. This is the ultimate measure of loan portfolio performance and a key indicator of asset quality problems.
Loan-to-Deposit Ratio Banks Measures a bank's liquidity by comparing total loans to total deposits. A ratio > 100% indicates a reliance on more volatile wholesale funding.
Combined Ratio P&C Insurance (Losses + Expenses) / Premiums. A ratio below 100% means the insurer is making an underwriting profit before investment income. A critical measure of underwriting discipline.
❗ Specific Risk Factors
  • Credit Risk: The risk that borrowers will default on their loans. This is the biggest risk for banks and is highly correlated with the economic cycle, particularly unemployment.
  • Liquidity Risk: The risk of not being able to meet short-term obligations. This is what causes bank runs (e.g., the failure of Silicon Valley Bank in 2023) when depositors withdraw funds en masse.
  • Systemic Risk: The risk that the failure of one large, interconnected institution could trigger a cascading failure throughout the entire financial system. This is why the sector is so heavily regulated.
  • Underwriting Risk (Insurers): The risk that premiums collected are insufficient to cover future claims, due to mispricing policies or higher-than-expected losses (e.g., a major hurricane).
💡 Monitoring & Underwriting Tips
  • Regulation is Everything: You cannot analyze a financial institution without understanding its regulatory environment. Capital and liquidity rules are the binding constraints on growth and shareholder returns. Follow releases from the BIS and national regulators.
  • For Banks, Watch Asset Quality Like a Hawk: Track trends in non-performing loans (NPLs), loan loss provisions, and net charge-offs. Are they rising? Are they concentrated in a specific sector like Commercial Real Estate?
  • For P&C Insurers, It's All About the Combined Ratio: A company that consistently posts a combined ratio below 100% demonstrates a strong underwriting culture and is less reliant on volatile investment income.
  • Assess the Funding Mix: For banks, a high percentage of stable, low-cost, insured retail deposits is a major credit positive compared to a reliance on more fickle and expensive wholesale funding.
  • Read the Footnotes: Financial institution accounting is notoriously complex. Pay close attention to disclosures on derivatives, loan portfolio composition, and the valuation of Level 3 assets.