Banking Special: Is E*Trade Safe and Sound?

Occasionally, I will analyze a financial institution and post my findings here. The final conclusions are my opinions, but they are based on the financial statements of each bank. Even though their information is accessible to the public, I feel that the costs of spending time to analyze all the data does not always outweigh the benefits. Therefore, I want to summarize the conditions of particular banks to make it more presentable and understandable. I will take suggestions for any banks that you may wish to be analyzed, so please let me know if you have any requests. 

E*Trade Bank, founded in 1982, is a popular financial services company providing an online stock brokerage service as well as banking services. It has received five stars from SmartMoney Magazine for its trading tools and five stars from Kiplinger's for customer service. It has been known for its superb experience provided to investors and creative marketing ideas through unique commercials. These are all commendable characteristics, but how safe and sound is the actual bank of E*Trade? It provides checking and saving accounts, money market accounts, certificates of deposit, and credit cards. Banking and investing through the same institution can be a convenient pairing, but only if the bank itself is reliable. I am going to examine two areas that determine a bank’s soundness: profitability and risk management. By taking these characteristics of E*Trade Bank and then comparing them to all U.S. Banks as a basis, we will be able to see that E*Trade isn't as stable as it seems.

PROFITABILITY
Profitability for banks is an essential ingredient to allow for stability and growth. When expenses greatly exceed revenues, the bank doesn’t have enough money to maintain itself and therefore goes bankrupt. When expenses equal revenues, the bank is not growing and is definitely not stable. Since money is constantly changing hands and you never know when loans will not be paid, to have no profit means having no cushion to absorb losses. Banks often use their capital as another back up for absorbing losses. The three basis measures of determining a bank’s profitability are basic spread, return on assets, and return on capital. The basic spread shows the difference between average loan interest rate average deposit interest rates. Ideally, a bank would want to have higher loan interest rates than deposit interest rates so that they can make money faster than they spend it. The basic spread average for all U.S. Banks is 5.05%, and keeping everything else constant, this is a good spread for generating profits. E*Trade’s basic spread is 4.66%. This is very close to the national average and is a good start for E*Trade in this analysis. Now, we must zoom in a little closer than basic spread. Return on assets (ROA) shows how profitable a company is relative to its assets. The national average is 0.85%. E*Trade trails closely behind with 0.78%. Although it is not very high, this is alright because a higher return usually means more risk as well. Earning return on your capital is another way to measure profitability. The ROK (return on capital) of all U.S. Banks is 7.47% as compared to E*Trade’s 6.61%. This is low which means less risk, but also means a low income of only $175, 994.The bank seems to be managing its assets well if it has a lot of capital proportional to its income, but a small company is still a risky company. From this information, we see that E*Trade has low returns but has a high spread. It isn’t a highly profitable company, but so far seems like it leaves cushion for losses through its capital. However, all of this could be canceled out if risk is poorly managed.

RISK
Risk management is the second essential component of running a bank and can be measured by the capitalization ratio, implied change in ROA, primary liquidity ratio, and credit loss rate. Poorly managed risk can deplete any available revenues that a bank generates. The first measure of risk management, the capitalization ratio, compares its long-term debt with its current equity and assets. This figure gives us a better picture of how likely the bank is going to become insolvent. The higher the capitalization ratio, the higher the risk because the bank is acquiring new debt in order to finance its operating costs. The national average is currently 11.44% in comparison to E*Trade’s 11.36%. In the long run, any ratio above 10% is generally undesirable. However, since E*Trade’s capitalization ratio is slightly lower than the average, it is still slightly more stable than a majority of U.S. Banks. This wide-spread insolvency risk can be attributed to the recent economic downturn.

Before assuming that E*Trade is the best to bank with, let’s look at its implied change in return on assets after a 1% increase in interest rates. The more susceptible the ROA is to a change of interest rates, the more unstable and risky the bank is. All U.S. banks have an average capitalization rate of -0.75% and E*Trade has a rate of -0.73%. This means that when rates increase 1%, E*Trade’s ROA decreases by -0.73%. This is because to calculate the implied change in ROA, you divide the implied profit change from a 1% increase in rates by total assets. The implied profit change is affected by how many rate-sensitive assets and liabilities the bank has (securities, federal funds, interest bearing deposits). E*Trade is doing better than the national average, but only slightly. From this, we can infer that E*Trade is not very risky when it comes to its interest rate risk.

The next measurement we look at is the primary liquidity ratio, or the cash that the bank has in proportion to its deposits. To be stable, the perfect amount of reserves is enough cash on hand for withdrawals everyday, yet reserves are also low enough so that they can maximize on profits. In the long run, this ratio is usually 9-10%. Currently, all U.S. banks have an average of 13.51% and E*Trade has a ratio of 4.79%. As you can see, they both go outside the usual range. The higher ratio that most U.S. banks have means that they have had bad loans in the past, therefore they stop lending in order to hold onto more capital as a back-up. U.S. banks are being more stingy than usual due to poor economic times. As for E*Trade, they seem to be very illiquid. We must also take into consideration that E*Trade is primarily an online institution; therefore they probably don’t carry much cash on hand. They probably don’t require high reserves because not many depositors withdraw frequently. Regardless, being so illiquid leaves E*Trade in a very risky state.

The last measurement of risk is the credit loss rate. We calculate this by dividing the charge-offs by capital and this shows how much the bank loses through bad loans. This rate should usually be at a safe 1%, however E*Trade’s and even the national average is uncomfortably high. The national average is 7.99% and E*Trade is 12.90% which is uncomfortably high. This means that banks all over America are losing money through bad loans. This would explain why banks have been so hesitant to issue out more loans.

CONCLUSION
Taking all these factors into consideration, I would not recommend banking with E*Trade. Nothing stood out that convinced me that it was better than most U.S. banks. It doesn’t have much profitability with a smaller spread than the national average and a very low return on assets and capital. As for risk management, measurements such as capitalization ratio, implied change in ROA, and credit loss rate were only slightly better than the national average. There’s a pretty big chance that I could find a better bank out there that has much better ratios and better liquidity. The low liquidity of E*Trade also worries me. It might be fine for investors to use as quick funds to transfer to their stock account, but using E*Trade as a main bank account seems undesirable. The combination of their low income, low reserves, and high credit loss rate doesn’t sit well with me. If they have given out bad loans, why aren’t they increasing reserves like most U.S. banks? I’m not questioning E*Trade as a stock brokerage at all, but I definitely wouldn’t put my money in a checking account there.

Data from FDIC's "Statistics on Depository Institutions (SDI)" Database