The banking business model is simple. Banks receive money from depositors and the capital markets and lend to borrowers,profiting from the difference, or spread. If a bank borrows money from a depositor at 4 percent and lends it out at 6 percent, the bank has earned a 2 percent spread, which is called net interest income. Most banks also make money from basic fees and other services, which is usually referred to as noninterest income. Combine net interest income and noninterest income to get net revenues, a view of the bank's top line. That's the banking model.
- Interest expense
= Net interest income
- Provisions for loan losses
+ Noninterest income
= Net revenue
The low cost of borrowing - combined with the advantae banks have on the lending side - allows banks to earn attractive returns on their spread.
That said, because many banks enjoy these advantages, we think there are few that truly have wide economic moats. Money is a commodity, after all, and financial products are generic. So what makes one bank beter than another? Here are a few examples of wide-moat banks with different strategies:
- Citigroup uses its worldwide geographic reach and deep product bench to increase revenues and diversify its risk exposure, which allows it to perform well in even difficult environments.
- Wells Fargo is an expert at attracting deposits which area key source of lower cost funds, and it has a deeply ingrained sales culture that drives revenues.
- Fifth Third has an aggressive sales culture, a low-risk loan philosophy, and a sharp focus on costs.
It's all about Risk.
Whether a financial institution specializes in making commercial loans or consumer loans, the heart and soul of bnking is centered on one thing: risk management. Banks accept three types of risk:
- liquidity, and
- interest rate,
and they get paid to take on this risk. Borrowers and lenders pay banks through interest or fees bcause they are unwilling to manage the risk on ther own, or because banks can do it more cheaply.
But just as their advantage lies in mitigating others' risk, banks' greatest strength - the ability to earn a premium for managing credit and interest rate risk - can quickly become their greatest weakness if, for example, loan losses grow faster than expected.