Like all businesses, banks profit by earning more money than what they pay in expenses. The major portion of a bank's profit comes from the fees that it charges for its services and the interest that it earns on its assets. Its major expense is the interest paid on its liabilities.
The major assets of a bank are its loans to individuals, businesses, and other organizations and the securities that it holds, while its major liabilities are its deposits and the money that it borrows, either from other banks or by selling commercial paper in the money market.
Banks increase profits by using leverage — sometimes too much leverage, which helped precipitate the credit crisis that occurred in 2007 to 2009. Profits can be measured as a return on assets and as a return on equity. Because of leverage, banks earn a much larger return on equity than they do on assets. For instance, in the 1st quarter of 2016, all financial institutions insured by the FDIC, which includes most banks, earned an average return on assets equal to 0.97%, whereas the return on equity was 8.62%.
Profit Measures: Return on Assets and Return on Owners' Equity
The traditional measures of the profitability of any business are it return on assets (ROA) and return on equity (ROE).
Assets are used by businesses to generate income. Loans and securities are a bank's assets and are used to provide most of a bank's income. However, to make loans and to buy securities, a bank must have money, which comes primarily from the bank's owners in the form of bank capital, from depositors, and from money that it borrows from other banks or by selling debt securities—a bank buys assets primarily with funds obtained from its liabilities as can be seen from the following classic accounting equation:
Assets = Liabilities + Bank Capital (Owners' Equity)
However, not all assets can be used to earn income, because banks must have cash to satisfy cash withdrawal requests of customers. This vault cash is held in its vaults, in other places on its premises such as tellers' drawers, and inside its automated teller machines (ATMs), and, thus, earns no interest. Banks also have to keep funds in their accounts at the Federal Reserve that, before October, 2008, paid no interest. However, because of the credit crisis that was occurring at that time, the Federal Reserve started paying interest on banks' reserves, although it is much less than market rates. A bank must also keep a separate account—loan loss reserves—to cover possible losses when borrowers are unable to pay back their loans. The money held in a loan loss reserve account cannot be counted as revenue, and, thus, does not contribute to profits.
The ROA is determined by the amount of fees that it earns on its services and its net interest income:
|Net Interest Income||=||Interest Received on Assets||-||Interest Paid on Liabilities|
|=||Interest Earned on Securities + Loans||-||Interest Paid on Deposits and Borrowings|
Net interest income depends partly on the interest rate spread, which is the average interest rate earned on it assets minus the average interest rate paid on its liabilities.
Interest Rate Spread = Average Interest Rate Received on Assets – Average Interest Rate Paid on Liabilities
Net interest margin shows how well the bank is earning income on its assets. High net interest income and margin indicates a well managed bank and also indicates future profitability.
|Net Interest Margin||=||Net Interest Income|
Average Total Assets
The ROA for banks:
|ROA||=||Fee Income + Net Interest Income – Operating Costs|
Average Total Assets
Average Total Assets
Because income is calculated over a time period, but assets, as a balance sheet factor, are determined at a particular time, average assets are used:
|Average Total Assets||=||Total Assets at End of Fiscal Year + Total Assets at Start of Fiscal Year|
(Note: Herein we will refer to Average Total Assets as simply Bank Assets)
The return on equity is what the bank's owners are primarily interest in because that is the return that they earn on their investment, and depends not only on the return of assets, but also on the total value of the assets that earn income. However, to purchase more assets, a bank needs to pay for it either with more liabilities or with bank capital. Therefore, if the owners want to earn a greater return, they would rather use liabilities rather than their own capital because this greatly increases their return.
When a bank increases its liabilities to pay for assets, it is using leverage—otherwise a bank's profit would be limited by the fees that it can charge and its interest rate spread. But the interest rate spread is limited by what a bank must pay on its liabilities and what it can charge on its assets. Since banks compete with each other for depositors and deposits compete with other investments, banks must a pay minimum market rate to attract depositors. Likewise, banks can only charge so much for loans since there is competition from other banks and businesses can get loans by selling debt securities, either commercial paper or bonds, in the financial markets. Hence, interest rate spreads are not wide, so a bank can only earn more net interest income by increasing the number of loans that it makes compared with the amount of its bank capital, which it does by using leverage:
|Leverage Ratio||=||Bank Assets|
Now the return for the owners is easy to calculate:
|ROE||=||Return on Assets × Leverage Ratio|
|=|| Net Income|
The leverage that banks use is basically the same as a business using debt to increase its earnings. After all, deposits are just money that the bank owes to its depositors. Hence, the leverage ratio is the same as the debt ratio used to determine the leverage of other business types.
The return on equity can be increased by increasing leverage, but banks can only increase leverage by so much, because with increased leverage comes increased risk. For instance, consider the following hypothetical bank:
- Bank Assets = $100
- Bank Liabilities = $95
- Bank Capital = $5
This is a leverage ratio of 20 to 1 ($100/$5). If the value of its assets drops just 5%, then the bank's capital will be wiped out.
To protect the safety of the banking system, the Federal Reserve restricts the amount of leverage that banks that are depository institutions can use. Typically, the leverage ratio is about 10 to 12. In other words, a bank's assets may have at least 10 times the value of its capital, but not much more.
A major reason why most investment banks were not depository institutions was to escape such restrictions, so that they could earn outsized profits by using extremely high leverage. Rather than managing risk with reserves, these banks managed risk with their own financial models. For example, Lehman Brothers was using a leverage ratio greater than 30. With a leverage ratio this high, the value of its assets only had to decline 3% to wipe out Lehman Brothers' entire capital. When subprime borrowers started defaulting on their mortgages in large numbers in 2007 and 2008, the value of the mortgaged-backed securities that Lehman Brothers held as part of its portfolio fell dramatically in value. These large losses combined with its outsized leverage ratio forced Lehman Brothers to declare bankruptcy in September, 2008, after 160 years in the financial services business.
This is why banks must manage risk very carefully.