Case Study: Banks in Hawaii

Studying banks in the middle of crisis could be interesting. I selected Hawaii as it is isolated and a dominant bank could be quite profitable. Plus, I think regional banking might be a way to invest in a place one likes.

I am surprised to find one of the best regional banks, Bank of Hawaii, there. The other banks on the island also provide a very interesting study of banking business. All the regional banks on Hawaii are summarized as follows:

1. First Hawaiin Bank: This is the largest bank in Hawaii with assets around $13 B. It is part of European bank BNP Paribas and is not publically traded. Based on FDIC data, this bank is well run and is a strong local competitor.

2. Bank of Hawaii: This is second largest bank in Hawaii with assets around $12 B. I will talk about it more later.

3. American Saving Bank: This bank has $5 B in asset and is part of Hawaiin Electric Industries. Based on a quick look, it is an average regional bank.

4. Central Pacific Bank: This bank has ~$5 B in asset and is trouble. I will talk about it more later.

5. Smaller banks: Hawaii Nation bank has $500 M asset and might be related to Chinese community on island. It is an average bank. Pacific Rim Bank is an e-bank and doesn\'t seem to be successful. Ohara Pacific Bank is a tiny bank traded on OB and doesn\'t look too healthy.

I didn\'t check presence of large banks on the island. Bank of Hawaii and Central Pacific Bank provide good examples for case study.

There are over 8000 financial institutions in US. Banking by nature is a commodity business. Due to FDIC insurance, anyone with enough capital can start a bank. There is an inherent paradox in banking in US:

1. In order to encourage competition, FDIC insurance allows anyone with capital and willingness to start a bank.

2. A bank is able to leverage capital 10:1 and thus bankers have a natural tendency to take risks.

In previous banking crisis, large number of small banks almost brought down the system. This time it was the large ones in 2008, with potentially small ones in 2010.

Traditional banking could be very boring and simple. One takes in deposit at 3% and lends it out at 6%. Bank of Hawaii is one of such banks.

It had around $10 B asset in 2008 with $6 B loans. Majority of the loans is residential mortgage with very small exposure to commercial loans. Over 90% of the loans is related to island in Hawaii. Its net return on asset is 1.8%, which is very high in banking industry.

The bank has solid community relationship as evidenced by its high net interest margin and high component of non-interest income. Its efficiency ratio is at around 50%.

When the crisis came, it was well prepared:

1. BOH didn\'t take TARP money. As a matter of fact, it is reducing long-term debt on its book and thus lay the foundation for future return for shareholders.

2. BOH\'s net charge off is at 0.5% of total loans yet its reserve for allowance is at 1.5%. Its pre-tax and pre-provision income is at 6% of total loans, one of the highest in the banking industry.

3. BOH is absorbing a large amount of retail deposit and its funding cost is very low. This is one of the reason it doesn\'t need long-term debt and can fund almost entire asset with deposits and common equity.

4. As one of two strong banks on Hawaii, any weakness of other banks will play into the hands of BOH. One that is coming is CPF.

BOH is a very solid and well-run bank. Its standing is comparable Canadian Chartered banks in terms of deposit and market position. Its quality may be better in that it has no exposure to meaninful derivatives and off-balance vehicles.

Going forward, it is not hard to foresee BOH starting to earn $4 per share and $40 per share in the next ten years. A revival of tourism in Hawaii and failure of CPF can probably increase the earning further. Of course, a major eruption of valcano or earthquake etc can also cause hardship to BOH...

Central Pacific Financials (CPF) is one of the second-tier bank on Hawaii island with total asset around $5 B. Here is its number as of Q3, 2009:

1. Tangible common equity: $161 M
2. Pre-tax and pre-provisioning earnings per quarter: $22 M

3. Non-performing assets: $418 M
4. Allowance for loan losses: ~$220 M

In other words, the company only has a cushion of ~$400 M total next quarter to absorb loan losses.

Its non-performing commercial loan stands at close to 10% of about $2 B commercial loans in Q3 ! Not only its loans in California has high default ratio but also loans in Hawaii.

In comparison, Bank of Hawaii\'s non performing asset is at around 0.5%, yet its credit allowance is at 1.4% of total loans and the pre-tax and pre-provision profit (a measure of a bank\'s earning power and ability to absorb credit losses) is at 5.5% of total loans.

Two banks on the same island yet totally different performance during this crisis.

As mentioned before, the FDIC insurance creates a type of paradox for banking industry. When time is good, people can leverage capital 10 to 1 and make a killing. If one is willing to lend money freely, he has no problem finding customers. It is very difficult for an outside investor to tell if the bank is swimming naked or not.

Now the tide is gone and the truth is revealed.

There are surely good banks like Bank of Hawaii in other parts of US and bad ones as well. Unless economy works out a miracle, many regional banks probably will fail.

The failures will provide a feast frenzy for good banks and enhance the earning power of latter in the years to come.