There's a Problem With This Bank's 15% Return on Equity

For the 2014 fiscal year, TD returned 14.7% on equity. The bank has produced at least a 13.3% annualized return on equity since 2011. According the most current Quarterly Banking Profile from the FDIC, the industry averaged a paltry 9% ROE for the 2014 third quarter. In fact, the industry hasn't averaged above 10% since the second quarter of 2007!

Pulling the wrong lever

Don't get too excited, though -- there's a problem we need to discuss. Return on equity relates the bank's profits with its equity. That's an important relationship, but its also one that can be manipulated by one specific, and dangerous, mechanism: leverage.

Currently, TD Bank has an assets to equity ratio of 16.8 times. That's roughly 50% higher than the rest of the industry. It is by no means as reckless as the 25 or 30 times that were common ratios in the mid-2000s, but it is an outlier in the industry.

That leverage successfully boosts the bank's ROE, but it hides an unimpressive efficiency ratio and return on assets figure. A bank's efficiency ratio compares non-interest expenses to the institution's net revenue. A lower ratio is considered more efficient. Return on assets uses the assets side of the bank's balance sheet to measure relative profitability, meaning that it effectively ignores leverage. Using the efficiency ratio and return on assets in tandem gives a very clear picture of the real profitability of the operations, without accounting trickery.

TD Bank, unfortunately, fails to impress with either metric. The bank's ROA was just 0.9% in the fourth quarter, trailing the industry average of 1.02%. The bank's efficiency ratio was reported at 58.1% for the fourth quarter, which is slightly better than the industry average: 60.8% per the FDIC.

What to think of TD Bank's profitability?

There is nothing inherently wrong with using leverage to boost return on equity. In the perfect bank stock, strong returns would come from an efficient operation. Both ROE and ROA would be strong. But in today's highly regulated world, that's not always possible.

The question boils down to risk. Operating with a more leveraged balance sheet gives TD Bank an industry leading ROE, but the trade off is a higher-risk profile. In my opinion, that trade-off is a recipe for disaster. There are other bank stocks with more efficient operations that can yield similar ROEs without the risks that come with extra leverage on the balance sheet.

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The article There's a Problem With This Bank's 15% Return on Equity originally appeared on Fool.com.

Jay Jenkins has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

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