The financial statements of banks differ from most companies when analyzing revenue. Banks have no accounts receivables or inventory to gaugewhether sales are rising or falling. Instead, several unique characteristics are included in a bank's balance sheet and income statement that help investors decipher how banks make money.
Key Takeaways
- A bank's financial statements differ from most companies when analyzing revenue.
- Banks acceptdeposits from consumers and businesses and pay interest in return.
- When the interest a bank earns from loans exceeds the interest paid on deposits, it generates income.
- In the U.S., banks are regulated by multiple agencies including the Federal Reserve System (FRS) and the Federal Deposit Insurance Corporation (FDIC).
How BanksMake Money
Banks acceptdeposits from consumers and businesses and pay interest in return.Banks invest those funds in securities orextend loans to companiesand consumers. When the interest a bank earns from loans exceeds the interest paid on deposits, it generates income from theinterest rate spread.The size of this spread is a determinant of a bank's profit.
Banks also earn interest from investing cashin short-term securities like U.S.Treasuries and from fees charged for their products andservices such as wealth management advice, checking account fees, overdraft fees, ATM fees,interest, and credit cards.
Example: Bank of America Corporation (BAC)
The table below combines a Bank of Americabalance sheet andincome statement todisplaythe yield generated from earning assets and interest paid to customerson interest-bearing deposits. Most banks provide this table in their annual 10K statement.
- In GREEN: Interest or yield is shown that BofA earned fromtheir investments and loans. Loans are assets because the bank earns interest income from loans.
- In RED: Interest expense and the interest rate paid to depositors are shown on their interest-bearing accounts. A deposit is a liability on a bank'sbalance sheet.
The balance sheet items areaverage balances for eachline item rather than the balance at the end of the period. Average balances provide a framework for the bank's financial performance.There is a corresponding interest-related income, or expense item, and theyieldfor the period.Bank of America earned$58.5 billion in interestincome from loansand investmentswhile paying out $12.9 billion for deposits.
:max_bytes(150000):strip_icc()/bac_2_10k_yield_-5bfd892446e0fb00518453e2 "Analyzing a Bank’s Financial Statements: An Example (1)")
Income Statement
An example of Bank of America's income statement is shown below with the following highlights:
- Total interest earned was $57.5 billion forthe bank fromloans, all investments, and cash positions.
- Net interest incometotaled$44.6 billion andis the spread between interest earned from loans and the interestpaid out to depositors.
- Non-interest income totaled $42.6 billion and includes fee income for products and services such as bank account and service fees, trust income, loan and mortgage fees, brokerage feesand wealth management services income, and income from trading operations.
- Net income of $18.2 billion is the profit earned.
A bank's revenue is the totalof the net interestincome and non-interest income.
:max_bytes(150000):strip_icc()/bofa_income_statement_10k_2017_investopedia-5bfd892ac9e77c0026700156 "Analyzing a Bank’s Financial Statements: An Example (2)")
Balance Sheet
Bank of America's balance sheet exampleincludes the following:
- Cash held as deposits is approximately $157 billion.
- Securities are typically interest-bearing short-term investments that include U.S. Treasuries and government agencies.
- Loans are commonly the largest asset on the balance sheet. BofAhas $926 billion in loans.
- Depositsare the largestliability for the bank and include money-market accounts, savings, and checking accounts. Both interest-bearing and non-interest-bearing accounts are included. Deposits are critical to the bank's lending ability.
:max_bytes(150000):strip_icc()/bofa_balance_sheet_10k_2017_investopedia-5bfd89284cedfd0026007224 "Analyzing a Bank’s Financial Statements: An Example (3)")
Although a liability on a bank's balance sheet, deposits are critical to the bank's lending ability.
Bank Regulation
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:
- Federal Reserve System (FRS)
- Office of the Comptroller of the Currency
- Office of Thrift Supervision
- Federal Deposit Insurance Corporation (FDIC)
Interest Rate Risk and Credit Risk
Interest rate risk is 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 rise, banks can charge a higher rate on their variable-rate loans and a higher rate on theirnew fixed-rate loans. If interest rates rise, banks tend to earn more interest income, but when rates fall, banks are at risk as interest income declines.
Credit risk reflects the potential that a borrower will default on a loan or lease, causing the bank to lose potential interest earned and the principal loaned to the borrower.
How Do Rising Interest Rates Affect a Bank's Revenue?
Changes ininterest rates may affect the volume of certain types of banking activities that generate fee-related income. The volume of residential mortgage loan originations typically declines as interest rates rise, resulting in lower originating fees. Banks tend to earn more interest income on variable-rate loans since they can increase the rate they charge borrowers, as in the case ofcredit cards.
Why Are a Bank's Loans Important to Investors?
Investors monitor loan growth to determine whether a bank is increasing its loans and using bank deposits to earn a favorable yield.
How Do Banks Handle Loss from Loan or Lease Default?
Banks maintain an allowance for loan and lease losses. This allowance is a pool of capital specifically set aside to absorb estimated loan losses and should be adequate to absorb the estimated amount of probable losses in the institution's loan portfolio. The loan loss provision is located on a bank's income statement.
The Bottom Line
The financial statements of banks will differ from those of non-financial companies. Analysts look at net interest margin income and other fundamentals to value bank shares. Banks accept deposits from consumers and businesses and pay interest in return. Banks use deposits to issue loans and earn interest. A bank generates income when the interest it earns from loans exceeds the interest paid on deposits.In the U.S., banks are regulated by multiple agencies, including the Federal Deposit Insurance Corporation (FDIC).
