Question

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Question:-
Discuss why investors are willing to buy shares in bank when:
i) the ROA of banks is typically quite low, and
ii) banks are subject to many restrictions and are closely monitored by the regulators

Answer 1

1) Companies use the return on assets (ROA) ratio to determine whether they are earning enough money from capital investments. These investments might include things such as building facilities, land, machinery and fleet vehicles. Managers and analysts use the return on assets ratio as a measure of performance. Comparisons between industrywide and internal prior year ratios might indicate a need for a company to use its assets more efficiently.

A low percentage return on assets indicates that the company is not making enough income from the use of its assets. In some cases, a low percentage return may be acceptable. For instance, if a firm recently purchased an expensive piece of machinery for one of its manufacturing plants, the return on that asset may be low for the first few years of operation. Afterwards it may give a good return which will be profitable to the investors. Keeping this aspect in mind that it may give a good return in the future the investors are willing to buy shares in banks which typically has quite low ROA.

2) There's no question, a lot of people like to play it safe with their money. And nothing seems safer than a bank. After all, they have the advantage of FDIC insurance on your deposits.

But from an investment standpoint, even FDIC insurance has limitations. It only insures your money for up to $250,000 per depositor. And while that seems like a lot of money, if you're a long-term investor – particularly when it comes to retirement accounts – you should have your sights set on much higher balances, at least eventually.

The other limit is that FDIC insurance only covers bank deposits. That means checking and savings accounts, money markets, and certificates of deposit.

If you do have any money in an investment account with a bank, those funds are not covered by FDIC insurance. In fact, bank investment accounts always come with microscopic fine print making that point clear. FDIC insurance doesn’t extend to stocks, bonds, mutual funds and other true investment assets.

But the problem is public perception. Because of FDIC insurance, the investor may be persuaded that their investments are fully insured. But if your funds are invested in anything other than bank deposits, they certainly are not.

It's also likely that some investors are drawn to banks because of their brick-and-mortar branches. Even though most investing is now handled electronically, there still might be some sense that an institution with physical branches is somehow safer than one that has few locations, or even not at all.

But when it comes to investing, perception is not reality. And that's why investing through your bank makes little sense.