Indeed, when comparing the smaller challenger banks to the likes ofStandard Chartered(LSE: STAN) andHSBC(LSE: HSBA), the smaller banks come out on top, simply because they are much easier to understand!
Terry Smith used to be one of the Citys top banking analysts, but today he wont touch the sector. Why? Because banks have just become too complicated even for some of the Citys top analysts.
Complex credit derivatives, high levels of leverage opaque accountancy practices have made it almost impossible to analyse the balance sheets of larger banks. For example, HSBC has a balance sheet with nearly $2trn of assets. So, its not possible to correctly assess every risk the bank is exposed to.
On the same note, few analysts predicted Standard Chartereds recent set of problems, as the banks huge exposure to risky credit was hidden away from many analysts.
Standard has been hit by its exposure to the Chinese and Indian resource sector, where falling commodity prices have pushed many smaller miners into liquidation. During the third quarter Standard reported a bad debt charge of $539m, up from $250m as reported during the second quarter. The total value of Standards impairments year to date is $1.6bn.
On top of risky, complex balance sheets, the larger banks are also being forced to fork out billions in fines for mistakes made in the past. These multi-billion dollar fines are forcing banks to dig into capital cushions to fund the payouts.
A simple solution
On the other hand, OneSavings and Virgin are relatively simple to understand.
OneSavings, which reported a fourfold increase in underlying profit before taxation during the first half of this year, has total equity and liabilities of only 4.2bn, with a balance sheet that can be understood by many of the banks investors. Whats more, due to the small size of the bank, it is able to get to know its customers, so impairment losses are small.
Only 22customers were three months or more in arrears on their mortgage payments during the first half of the year. Total impairment losses only came to 4.7m during the first half, thats 0.29% of One Savings total loan portfolio.
Similarly, after reading through Virgins half year report, you get the feeling that you know and understand the bank. In particular, the company lays out its mortgage portfolio, showing the quality of loans and stating that the averageloan-to-value ratio of the portfolio improved to 58.7% in June 2014.
Once again, conservative lending criteria helped the bank keep the volume ofmortgages over threemonths in arrears low, at only 0.32% of the mortgage book at the end of the first half, compared tothe industry average of 1.5%. Virgins balance sheet is slightly larger than that of OneSavings, with loans in excess of 21bn.
What to do?
So, the simplicity of Virgin and OneSavings make them better investments than HSBC and Standard. As a quick comparison, Ones half year report is around 42 pages long HSBCs half-year report weighed in at a staggering 300 pages!
However, before you make any trading decisionI strongly advise that you take a closer look at HSBC, Standard Chartered and the wider banking sector in general.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.