The reported financial statements for banks are somewhat different from most companies that investors analyze. For example, there are no accounts receivables or inventory to gauge whether sales are rising or falling. On top of that, there are several unique characteristics of bank financial statements that include how the balance sheet and income statement are laid out. However, once investors have a solid understanding of how banks earn revenue and how to analyze what's driving that revenue, bank financial statements are relatively easy to grasp.
How Banks Make Money
Banks take in deposits from consumers and businesses and pay interest on some of the accounts. In turn, banks take the deposits and either invest those funds in securities or lend to companies and consumers. Since banks receive interest on their loans, their profits are derived from the spread between the rate they pay for the deposits and the rate they earn or receive from borrowers. Banks also earn interest income from investing their cash in short-term securities like U.S. Treasuries.
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.
Analyzing A Bank's Financial Statement
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.
- Below we can see (in green) the interest or yield that BofA earned from their investments and loans in 2017.
- 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 than 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.
Bank of America's balance sheet is below from their annual 10K for 2017.
There are three key areas of focus:
- Cash is cash held on deposit, and sometimes banks hold cash for other banks. BofA has roughly $157 billion in cash which is an important focus for investors that are hoping for the bank to increase its dividend or share buybacks.
- Securities are typically short-term investments that the bank earns a yield from that include U.S. Treasuries and government agencies.
- Loans are the bread and butter for most banks and are usually the largest asset on the balance sheet. BofA has $926 billion in loans. Investors monitor loan growth to determine whether a bank is increasing their loans and putting to use the bank's deposits to earn a favorable yield.
- Deposits are the largest liability for the bank and include money-market accounts, savings, and checking accounts. Both interest bearing and non-interest bearing accounts are included. Although deposits fall under liabilities, they are critical to the bank's ability to lend. If a bank doesn't have enough deposits, slower loan growth might result, or the bank might have to take on debt to meet loan demand which would be far more costly to service than the interest paid on deposits.
Leverage and Risk
Banking is a highly-leveraged business requiring regulators to dictate minimal capital levels to help ensure the solvency of each bank and the banking system. In the U.S., banks are regulated by multiple agencies, and some of them include the Federal Reserve System (FRS), the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Deposit Insurance Corporation (FDIC). These regulators focus on ensuring compliance to uphold the soundness and integrity of the banking system.
Interest Rate Risk
Banks take on financial risk when they lend at interest rates that are different than the rates paid to depositors. Interest rate risk is the management of the spread between interest paid on deposits and received on loans over time.
Deposits are typically short-term investments and adjust to current interest rates faster than the rates on fixed-rate loans. If interest rates are rising, banks can charge a higher rate on their variable-rate loans and a higher rate on their new fixed-rate loans. However, the deposit rates don't typically adjust as much as the long-term rates which are used to price loan rates. As a result, as interest rates rise, banks tend to earn more interest income, but when rates fall, banks are at risk since their interest income declines.
One way banks try to overcome interest rate risk is through fee income for products and services. As a bank increases its fee income, it becomes less reliant on the interest income from loans, mitigating interest rate risk (somewhat).
Credit risk is the likelihood that a borrower will default on a loan or lease, causing the bank to lose any potential interest earned as well as the principal that was loaned to the borrower. As investors, these are the primary elements of risk that need to be understood when analyzing a bank's financial statement. To absorb these losses, banks maintain an allowance for loan and lease losses.
In essence, this allowance can be viewed as a pool of capital specifically set aside to absorb estimated loan losses. This allowance should be maintained at a level that is adequate to absorb the estimated amount of probable losses in the institution's loan portfolio.
Arriving at the provision for loan losses involves a high degree of judgment, representing management's best evaluation of the appropriate loss to reserve. Because it is a management judgment, the provision for loan losses can be used to manage a bank's earnings. Looking at the income statement above, we see that the loan-loss provision ultimately reduced the bank's net income or profit.
Investors should monitor whether there's an upward trend in loan-loss provisions as it might indicate that management expects an increasing number of problem loans. Substantially higher loan and lease losses might cause a bank to report a loss in income. Also, regulators could place a bank on a watch list and possibly require that it take further corrective action, such as issuing additional capital. Neither of these situations benefits investors.
Overall, a careful review of a bank's financial statements can highlight the key factors that should be considered before making an investment decision. Investors need to have a good understanding of the business cycle and interest rates since both can have a significant impact on the financial performance of banks.