How else would you have been able to safely and securely transfer emergency funds to a factory in the Philippines overnight? Or have secured that bridge loan to cover the final phase of a masterplanned community in Southern California?
Like your business, businesses around the world have evolved to rely heavily on banks for a wide range of financial services. This is because, at the core, banks are the fundamental channel for the movement of money across the globe, offering safe products and services for holding and transferring funds. Just as important, banks fuel economic growth by lending to consumers and businesses to help them achieve their financial goals.
There’s a lot that goes into this core business, and understanding how banks operate and make money at a high level is beneficial to any C-suite leader. As with any bank you have a business relationship with, it is important to know how central it is to our business to operate in a safe and predictable manner that provides value to our clients at every stage of the relationship cycle.
How banks make money
Let’s start with what most business executives already know—the very basic business model: banks hold deposits from both consumers and businesses and then use a portion of that money to issue loans on which they, in turn, earn interest. Even at this very basic level, it’s important to pause and appreciate the level of trust that people have in banks—to not only hold their money, but also to lend that same money back to help satisfy the financial needs of consumers and businesses in a community. Risk management and prudent oversight is, therefore, paramount to the soundness of the banking system.
Since the last recession a decade ago, regulators have introduced several requirements for banks that aim to provide increased stability within the banking system. The requirements include safeguards to ensure banks have the capital and liquidity to meet all on- and off-balance-sheet commitments.
Understanding a bank’s income statement
Most corporate income statements show measures like sales and cost of goods sold, so it’s easy to gauge whether sales and profitability are rising or falling. Because a bank’s primary business is to manage the spread between deposits paid to customers and the rate received from loans, a bank’s income statement is somewhat different, as shown here.
How do banks earn revenue?
Banks earn revenue from two main sources: interest income and noninterest or “fee” income.
- Interest Income: This is the income banks earn from charging interest on loans. As a commercial loan customer, you are used to seeing loan pricing based on an underlying index, such as LIBOR or Prime, plus a spread. Some banks might quote an all-in rate, but even an all-in rate is usually tied to LIBOR or Prime. Regardless of how your rate is quoted, the total interest paid is the gross interest income (revenue) the bank earns on your loan.
- Interest Expense: Like other industries (for example, manufacturing companies), banks incur costs to source the funds they use to in turn provide loans to customers. At a manufacturing company the direct cost to produce salable goods is identified as the Cost of Goods Sold, while at a bank it is called the Cost of Funds. Cost of Funds for a bank is the bank’s interest expense: what a bank pays to its customers to hold their deposits, as well as any borrowing costs the bank incurs on the short-and long-term debt it carries.
- Net Interest Income: This is simply the difference between gross interest income and total interest expense or Cost of Funds. While the calculation might be simple, the ongoing management of this figure is anything but simple. Interest expense for a bank is predominantly tied to short-term interest rates, and these rates are set by the Federal Reserve. A bank must therefore actively manage the difference in interest rates earned compared to the interest rates it pays out in order to maintain profitability.
- Non-Interest Income: This is a catch-all category for the various service fees banks earn for everything from treasury management solutions to syndication fees to investment portfolio management fees and others. As banking continuously evolves, the complexity of the business and the services offered have expanded tremendously. Customers demand new types of services (e.g., fraud protection, interest rate hedging options) and desire ways of automating financing and accounting functions. The fees earned on these products and services offered to clients are captured in this non-interest income category.
What are a bank’s expenses?
Banks have expenses just like every other business (employee salaries/ benefits, IT, legal, etc.), but we’ll focus on a couple key ones unique to banking, namely loan loss provision and compliance costs.
- Loan loss provision: Loans are an asset on a bank’s balance sheet and can be seen as somewhat similar to accounts receivable in other industries. Just like other companies regularly assess the quality of their receivables and make provisions for write-offs, so too do banks. Yet for banks, the calculation of loan loss provision is highly regulated, requiring models to be developed to assess both quantitative and qualitative factors that indicate how likely a loan is to deteriorate. Every single loan is assigned a risk rating, and these ratings factor into what shows up on a bank’s income statement as the change to its loan loss provision. As risk increases (during a recession, for example), the reserve a bank must hold increases and therefore reduces the profitability for the bank. Yet when overall risk decreases, it is possible to see a bank reverse some of the provisions and see an improvement in net profit. It’s important for C-suite leaders to understand that loan loss provision impacts every loan and, therefore, has a direct impact on the loan pricing a bank is willing to offer. Two companies might have identical loans on paper with regard to amount, structure, and interest rate, but the profit earned by the bank on each loan might differ if the risk profiles of the two companies are different.
- Compliance/regulation costs: We’ve already noted that banking is highly regulated, and those regulations continue to evolve every year. There are good reasons for regulation, and yet it introduces a significant cost to banks that many other industries may not experience to the same degree. And not all banks are regulated based on the same standards, either: a bank’s size, complexity, risk profile, and level of interconnectedness to the financial system determine the level of regulatory and supervisory insight that’s required. They also define the banking regulators’ expectations about the design and overall robustness of a bank’s enterprise-wide regulatory compliance management framework. Some industries, such as wineries, can outsource a large portion of the compliance work for keeping on top of alcoholic beverage rules in various states. A bank can’t do that, so a significant part of the cost structure for a bank involves putting robust teams in place to deliver on the transparency necessary to keep the banking system healthy.
The bottom line
Net profit: After accounting for all costs (loan loss provision, compliance, and all the other standard costs a company incurs, including taxes), we arrive at the net profit for a bank. As with every other viable business, earning a reasonable profit is vital for a bank’s stability. Profit supports the liquidity needs of the banking system, is reinvested for technological innovations demanded by clients, and improves compliance systems that help combat economic issues such as fraud.
Why does this matter?
Understanding how a bank makes money puts a C-suite leader in a better position to assess the quality and stability of any bank you might consider as a business partner. This is important because the overall health of a bank has a direct impact on its ability to continue providing capital during all economic cycles.
During times of prosperity, it can be easy to consider only pricing. But when the economic environment gets challenging, it becomes paramount to be able to rely on a partner that stands by you with innovative solutions, enhanced by an outstanding level of client service, over the long term— through both up markets and down.