I recently dug up an old (2014) article from Terry Smith, manager at Fundsmith, titled ‘Why I don’t own bank shares’. In fact, he says he never will. While he does own financials like MSCI and Visa, he has stuck to his word and avoided traditional banks.

“I’ve often been asked why I won’t invest in bank shares given that I was once the top-rated rated banking analyst in the City. The answer is that having an understanding of banks would make anyone more wary of investing in them”.

He claims that one of his core tenets as an investor is “never to invest in a business which requires leverage or borrowing to make an adequate return on equity”. While the companies in the Fundsmith portfolio do rely on borrowing to varying degrees, they do not require it to survive like banks. But there is an upside to being highly leveraged, he claims.

“The good news about such high leverage is that when something goes wrong, at least you go bust quickly”.

In a more ominous manner, he remarks that bank runs are a more pernicious and often forgotten threat to owning banks.

“Investors had forgotten about the credit cycle until 2007, and when credit is withdrawn sometimes it is withdrawn from banks as well as their customers. When I was analysing banks in the 1980s it was possible to gauge a bank’s exposure to bad debts or credit risk, interest rates and currencies. With the advent of over-the-counter derivatives in these products, which began with interest rate swaps in the 1980s, this is no longer possible. Someone working in the bank’s treasury department may have altered all those exposures with a phone call or the click of a mouse and there is no way for investors to know. Judging by the events of the financial crisis, it is clear that a fair few bank managers were in the dark too”.

Even when there is no rational reason for a bank run to occur, the fragility of banks ensures that even the largest institutions are not immune to the threats which can arise from systemic risk.

“The fragility of banks is illustrated by a story from the 1980s, when there was a wave of nervousness in Hong Kong following the signing of the joint declaration regarding the colony’s handover to China. Property prices began to collapse and banks ran up bad debts as result. During this febrile period, a queue of people waited for a bus. It started to rain, and the queue moved across the pavement to shelter under the cover of a canopy on a building, which happened to house a branch of a local family-controlled bank. Passers-by, seeing the queue, concluded that there was a problem with the bank. Rumours of a run spread rapidly and by the following day the bank was besieged by depositors demanding to withdraw their savings”.

He concludes by suggesting that if you must own banks, then own retail banks; those which simply take deposits and lend their money to their own customers. Nothing exotic. While he reaffirms that he will never own a bank, this is where he states he would look if he ever had to.

I think this is pertinent advice for a retail investor that is not well-versed in banking. You are supposed to know what you own, but how many everyday investors truly know how to translate a bank balance sheet?