Commercial Bank Business Model
SPREAD BUSINESS
Banks typically earn money by generating a spread between the price they pay for borrowed funds (deposits and other interest-bearing liabilities) and the yield generated when they invest those funds in loans and securities. Read More >
Interest Income, Earning Asset Yields and Earning Assets
The interest rates charged by banks typically incorporate a spread over a reference or benchmark rate and reflect their optimization of yields for risk, interest rates, maturities and asset/funding mix, among other factors. Interest income is typically modeled by multiplying the interest yield times an underlying earning asset (daily averages are commonly used). Loans and loan growth are key factors tracked by analysts and are both highly influenced by the macro-economic environment.
Interest Expense, Cost of Funds and Interest Bearing Liabilities
The interest rates paid by banks reflect the mix of funding (demand deposits vs. borrowed funds) and the cost of those funds. Interest expenses are typically modeled by multiplying the cost of funds times an underlying interest-bearing liability (daily averages are commonly used).
Net interest income is the difference between interest income and interest expense. To evaluate and compare the spread business’s strength, analysts will often look at a bank’s net interest margin (NIM), which measures the net profitability of a bank’s investment in earning assets. NIMs are defined as a yield and calculated by dividing net interest income by average earning assets. Differentials in this value between banks can reveal differences in their business focus – retail vs. commercial – and the riskiness of their investment portfolio (e.g., credit cards vs. home mortgages). The ratio of loans-to-deposits will influence the overall margin, while also revealing a bank’s asset/liability mix, along with its source of funding (cheap demand deposits vs. expensive liabilities).
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NON-INTEREST INCOME
In addition to the spread business, banks also generate fee income from services provided to their retail and corporate customers and fees charged for products like credit cards and deposit accounts. Large diversified banks may also offer investment banking, asset and wealth management, and other related services. Read More >
Analysts will look at the ratio of non-interest income to total revenue to analyze revenue mix. Over the past few decades, commercial banks have increased the proportion of their revenue from non-interest sources, given its greater stability and predictability over spread-related income.
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NON-INTEREST EXPENSES
Typically, compensation is the largest category of non-interest expenses. In addition to labor costs, banks also incur large expenses associated with their branch network (mainly traditional retail banks), technology infrastructure and processing costs. Read More >
Analysts evaluate the operating efficiency of a bank using the ratio of non-interest expenses to total revenue. This ratio is commonly known as the efficiency ratio in the United States and the cost-to-income ratio in other geographies. The level of this ratio, its trend (down is preferable), and how it compares to peers will help with expense analysis.
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CREDIT QUALITY
Management of credit risk is a crucial undertaking at banks. Underwriting credit includes an evaluation of the likelihood that a loan or an investment will not be repaid. Banks factor these costs into their pricing of credit by charging higher interest rates for riskier assets. Credit costs are also recognized as an expense in the income statement in the form of a provision for loan and credit losses. Read More >
Credit quality can be evaluated using several measures, of which the most common are:
- Provision for Loan and Lease Losses is the income statement expense recognized for expected credit costs. Analysts look at the size of this account, the trend and the level compared to loans or earnings. The macro-economic environment and credit cycle will play a large role in the level and trend of credit costs. A deteriorating economic environment will generally lead to an increase in credit costs.
- Loans (or assets) are classified as non-performing when they are past due by a certain amount of days (varies by country), when interest is no longer accrued or if they are in the process of being restructured.
- When non-performing loans are deemed to be permanently impaired, they are written off. The ratio of non-performing loans to total loans is used to measure the overall quality of the credit portfolio, while the ratio of NPLs to allowance for loan and lease losses will indicate the level of reserves against loan losses.
- Charge-offs are loans that have been written off in a process that removes them from the balance sheet. This account can often be found as both a gross and net value (net of credit recoveries). The ratio of charge-offs to net loans is used to identify the level and trend of loan losses.
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BANK ACCOUNTING AND CREDIT QUALITY
To remove an impaired loan from the balance sheet, banks need to first recognize the loss as an expense. Income statement credit losses do not directly remove the loan, but instead increase the value of a contra-asset account called the allowance for loan losses. Loans are written off against these allowances (the term reserves is used in other geographies). Analysts will typically model the interplay of non-performing loans and the allowance for loan losses as follows:
| Non-Performing Loans (Asset) | Allowance for Loan Losses (Contra-Asset) | |
|---|---|---|
| Beginning of Period: | Non-Performing Loans | Allowance for Loan Losses |
| Plus: | New Non-Performing Loans | Provision for Loan and Lease Losses |
| Less: | Net Charge-offs | Net Charge-offs |
| End of Period: | Non-Performing Loans | Allowance for Loan Losses |
Impaired loans are removed by charging them off the balance sheet by using a previously established expense allowance. In the example above, a charge-off will reduce both the balance of non-performing loans as well as the allowance for loan losses.
CAPITAL ADEQUACY
As regulated entities, banks are required to maintain minimum capital standards, which impacts their ability to leverage their balance sheets. Higher capital requirements can decrease risk by requiring capital to absorb losses, but can also constrain asset growth and negatively impact profitability by making it more difficult to earn higher equity returns. Read More >
These capital adequacy ratios and measures are most commonly used by analysts:
- Equity % Assets is a traditional measure of leverage. This ratio has an inverse relationship with leverage in that a lower equity-to-assets ratio implies a higher level of leverage, and a higher equity-to-assets ratio suggests a lower level of leverage.
- Common Equity Tier 1 (CET1) Capital ratio is a measure of leverage used by regulators and is defined as Tier 1 Capital divided by risk-weighted assets (RWA).
- Common Equity Tier 1 (CET1) Capital is the sum of common stock (Paid-in-Capital, Additional Paid-in-Capital), retained earnings, other comprehensive income, qualifying minority interests, other qualifying capital instruments and other regulatory adjustments.
- RWAs are calculated by weighting a bank’s on and off-balance sheet assets by risk. Higher risk assets like loans will carry a higher weighting (e.g., 100% for consumer loans) than lower risk assets like U.S. Treasuries (0%).
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PROFITABILITY AND DISTRIBUTIONS
Analysts use asset and equity returns to evaluate and compare the profitability of banks. The two most commonly used measures of profitability are: Read More >
- Return on Assets (RoA) – defined as net income divided by assets or average assets – captures management’s ability to generate a return over the assets it controls.
- Return on Equity (RoE) – defined as net income divided by equity or average equity – measures management’s ability to generate a return on shareholders’ equity. This ratio can be compared to peers and against the cost of equity capital to identify a bank’s ability to create shareholder value. Compared to peers, capital structure and, in particular, higher capital requirements will impact excess returns.
Distributions
When banks are profitable, they will return capital to shareholders by paying dividends and/or by repurchasing shares. Payout ratios (dividends and/or repurchases relative to earnings) are used to analyze bank distributions. The amount and levels of distributions are subject to regulatory requirements. More profitable and better-capitalized banks have more flexibility to provide higher payouts.
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