The financial statements issued to banks are very different from those of many companies that investors analyze. For example, count or count would not be accepted to determine whether the result is increasing or decreasing. In addition, many unique features of bank financial statements include the way documents show the use of funds and income. However, once investors have a clear understanding of how the bank generates income and how to analyze the causes of the money, the bank’s financial statements become easy to understand.
How do banks make money?
Banks provide deposits to customers and merchants and pay interest on some accounts. Banks also take deposits and invest the money in shares or lend to companies and customers. Because banks receive interest on their loans, their interest arises from the difference between the rate at which they invest and the rate at which they obtain or borrow from borrowers. Banks also benefit from investing in short-term securities such as U.S. Treasury. However, banks also earn revenue from fee income that they charge for their products and services that include wealth management advice, checking account fees, overdraft fees, ATM fees, interest and fees on credit cards.
The primary business of a bank is managing the spread between deposits that it pays consumers and the rate it receives from their loans. In other words, when the interest that a bank earns from loans is greater than the interest it pays on deposits, it generates income from the interest rate spread. The size of this spread is a major determinant of the profit generated by a bank. Although we won’t delve into how rates are determined in the market, several factors drive rates including monetary policy set by the Federal Reserve Bank and the yields on U.S. Treasuries. Below we’ll take a look at an example of how the interest rate spread looks for a large bank.
An Inside Look at Bank of America Corporation (BAC)
The table below ties together information from Bank of America’s balance sheet and income statement to display the yield generated from earning assets and interest paid to customers on interest-bearing deposits. Most banks provide this type of table in their annual 10K statement. The bottom of the table (in red) shows the interest expense and the interest rate paid to depositors on their interest-bearing accounts. It may appear counterintuitive that the deposits are in red and loans are in green. However, for a bank, a deposit is a liability on its balance sheet whereas loans are assets because the bank pays depositors interest, but earns interest income from loans. In other words, when your local bank gives you a mortgage, you are paying the bank interest and principal for the life of the loan. Your payments are an income stream for the bank similar to a dividend you might earn for investing in a stock. You’ll notice the balance sheet items are average balances for each line item, rather than the balance at the end of the period. Average balances provide a better analytical framework to help understand the bank’s financial performance. There is also a corresponding interest-related income, or expense item, and the yield for the time period.
In the above table, BofA earned $58.5 billion in interest income from loans and investments (highlighted in purple) while simultaneously paying out $12.9 billion in interest for deposits (highlighted in lite blue). The numbers above only tell part of the story. The total income earned by the bank is found on the income statement.
Bank of America’s income statement is below from their annual 10K for 2017. Here are the key areas of focus:
Total interest earned was $57.5 billion (in green) for the bank from their loans and all investments and cash positions.
Net interest income (in blue) totaled $44.6 billion for 2017 and is the income earned once expenses have been taken out of interest income. Again, net interest income is mostly comprised of the spread between interest earned from loans and the interest paid out to depositors.
Non-interest income totaled $42.6 billion for 2017, and this income includes fee income for products and services. It’s vital that banks diversify their revenue streams by earning income from non-interest rate related products to shield them from any negative moves in yields. Income under this category includes bank account and service fees, trust income, loan and mortgage fees, brokerage fees and wealth management services income, and income from trading operations. We can see that BofA’s revenue is well balanced with roughly half of the bank’s revenue coming from fee and service income.
Net income of $18.2 billion is the profit earned by the bank for 2017.
Revenue for a bank is different from a company like Apple Inc. (AAPL). Apple’s income statement will have a revenue line at the top titled net sales or revenue. However, a bank operates differently. For a bank, revenue is the total of the net-interest income and non-interest income. To make matters confusing, sometimes analysts quote total interest income instead of net interest income when calculating revenue for banks, which inflates the revenue number since expenses haven’t been taken out of total interest income.
Changes in interest rates may affect the volume of certain types of banking activities that generate fee-related income. For example, the volume of residential mortgage loan originations typically declines as interest rates rise, resulting in lower originating fees. In contrast, mortgage-servicing pools often face slower prepayments when rates are rising, since borrowers are less likely to refinance. As a result, fee income and associated economic value arising from mortgage servicing-related businesses may increase or remain stable in periods of moderately rising interest rates.
Also, as interest rates rise, banks tend to earn more interest income on variable-rate loans since they can increase the rate they charge borrowers as in the case of credit cards. However, exceedingly high-interest rates might hurt the economy and lead to lower demand for credit, thus reducing a bank’s net income.
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