How do Banks make Profits?

A bank generates its income from three main sources.

1. There is the net interest rate difference between what it earns on loans and what it pays for deposits.
2. There are the extra fees it charges for various services and
3. There is the profit it earns from other activities like running a stockbroking division, a funds management business and offering services to customers like helping them with foreign exchange transactions.

Banks can also be involved as active traders in financial markets.

As far as the income they earn is concerned, this is generally about 3 per cent of the value of the multi billion dollars of assets for which they are responsible.  

• About 2.4 per cent of this 3 per cent comes from interest income and 
• about 0.6 per cent from fees and other income.

From this it pays running expenses that reduce the income on total assets to about 2 per cent. 

The other major cost is allowing for bad debts, which can arise from people not being able to pay their interest as well as from losses on bank business enterprises.

• These expenses can range widely from 0.2 per cent of assets when times are good to more than 1 per cent during bad times. 

Last but not least is tax which reduces any net income by 30 per cent.

From these basic observations, the major challenge banks currently face in developed countries comes from bad debts.

Summary:

3 Main Sources of Income

(1) Interest Income = 2.4% of Total Assets

(2) Fees and (3) other Income = 0.6% of Total Assets

Total Income = 3.0% of Total Assets

less

Expenses = 1% of Total Assets

Profit before provisioning for bad debts and before tax = 2% of Total Assets

less 

Provisioning for Bad Debts = 0.2% to 1% of Total Assets

Profit Before Tax = 1.8% - 1% of Total Assets

less 

Tax = 30%

Profit After Tax = 1.26% - 0.7% of Total Assets

Besides looking for a consistent mid- to high-teen ROE, it is good to see a high level of ROA as well.


For banks, a top ROA would be in the 1.2% to 1.4% range.






Related:
What should investors look for when investing in banks and other financiers?
http://myinvestingnotes.blogspot.com/2010/05/what-should-investors-look-for-when.html

Comparative Analysis of Banking Stocks (16.5.2010)

http://myinvestingnotes.blogspot.com/2010/05/comparative-analysis-of-malaysian.html

http://spreadsheets.google.com/pub?key=t3v2VY0rD9DcGSjmVkAV-gQ&output=html

How to analyze the market?  Bank

http://myinvestingnotes.blogspot.com/2008/08/how-to-analyze-market-bank.html

Hallmarks of Success for Banks: ROE and ROA
http://myinvestingnotes.blogspot.com/2009/06/hallmarks-of-success-for-banks-roe-and.html

Banking Basics

http://wfhummel.cnchost.com/bankingbasics.html

Economic performance of a Bank (National Australia Bank 2005)

Year 2005

Table 17: Gross value add in the community17
Year to 30 September 2005	$m
Net interest income	7,082
Fee income	4,157
Trading income	656
Net life insurance income	1,672
Other income	289
Net operating income	13,856
Significant revenue	2,493
Total net income	16,349
Other costs18	(3,811)
Movement in excess of net market value over net assets of life insurance controlled entities	335
Significant expense	(2,209)
Total	10,664
17 Gross value add in the community for the Group includes Australia, Europe, New Zealand, the United States and Asia. 18 Excludes salary-related costs, income tax relating to ordinary activities, payroll tax, fringe benefits tax, depreciation and goodwill and includes outside equity interests.

Table 18: 2005 distribution of community value
Distribution of community value	Australia $m	Europe $m	New Zealand $m
Shareholder19	2,125	1,525	424
Government20	1,665	251	131
Employees21	2,348	1,205	325
Depreciation & goodwill	268	175	73
19 Net profit attributable to ordinary shareholders. 20 Includes income tax relating to ordinary activities, payroll tax and fringe benefits tax. Excludes net GST and VAT payments. 21 Salary-related costs, excluding payroll tax and fringe benefits tax.

Interest expense
Year to 30 September 2005	$m
Deposits and other borrowings	10,401
Other financial institutions	1,780
Bonds, notes and subordinated debt	1,494
Other debt issues	115
Total interest expense	13,790

Full year dividend     166 cents

On 9 November 2005, a final dividend of 83 cents per full-paid ordinary share, 80% franked, was declared in respect of the year ended 30 September 2005. This brings the full year dividend to 166 cents (80% franked). Refer to Figure 22.

Diluted earnings per share     248 cents (after significant items)

Diluted earnings per share (after significant items) increased 26.5% from 196 cents to 248 cents. Refer to Figure 22.







http://www.nabgroup.com/0,,76586,00.html

Average Return on Equity and Assets at Commercial Banks

http://www.extension.iastate.edu/agdm/articles/others/HenMay09.html

Time to be realistic about bank investments

Time to be realistic about bank investments
JOHN WASILIEV
July 13, 2010 - 1:12PM

Most long-term investors own shares in at least one, two or even more banks in their share portfolios. With solid dividends and the potential for capital gains if you buy when markets are going through a down period, banks are well worth taking an interest in.

While the outlook for them is considered to be positive and most financial commentators point to how well Australian banks have survived the global financial crisis, one investment expert cautions that investors should not get too carried with expectations for bank investments.

It’s still a tough market out there for banks, warns John Abernethy, chief investment officer with the Clime Investments StockVal share investing research service. Although they may appear to be quite complex, from a fundamental perspective banks are relatively simple businesses to understand. For such major multi-billion dollar enterprises, they have remarkably few moving parts.

A bank generates its income from three main sources.

1. There is the net interest rate difference between what it earns on loans and what it pays for deposits. 
2. There are the extra fees it charges for various services and 
3. there is the profit it earns from other activities like running a stockbroking division, a funds management business and offering services to customers like helping them with foreign exchange transactions. 

Banks can also be involved as active traders in financial markets.
As far as the income they earn is concerned, Mr Abernethy says this is generally about 3 per cent of the value of the multi billion dollars of assets for which they are responsible.

1. About 2.4 per cent of this 3 per cent comes from interest income and 
2. about 0.6 per cent from fees and other income.

From this it pays running expenses that reduce the income on total assets to about 2 per cent. The other major cost is allowing for bad debts, which can arise from people not being able to pay their interest as well as from losses on bank business enterprises.

These expenses can range widely from 0.2 per cent of assets when times are good to more than 1 per cent during bad times. Last but not least is tax which reduces any net income by 30 per cent.

From these basic observations, the major challenge banks currently face comes from bad debts.

An important issue for Australian banks, says Abernethy, is the growing level of Australian household debt. At present, Australian households owe $1.3 trillion, which is slightly more than the $1.2 trillion of total superannuation savings and equal to the annual value of all the goods and services Australia produces. A trillion dollars is $1000 billion.

Compared to the income households earn, the debt is 50 per cent more, or 150 per cent of income. As a percentage of income, Australia has one of the highest levels of debt in the world, says Abernethy.

From a bank perspective one major problem this creates is households not having the money to deposit with banks that banks can in turn lend to households and businesses wanting to borrow.

This is forcing Australian banks to seek money from offshore investors in places like Europe, America and Asia to keep the all important business of lending money for interest income going. There is a lot of demand at the present time for deposits, which is causing interest rates to increase. Abernethy believes the Reserve Bank of Australia doesn’t really need to keep increasing interest rates. It is already happening because banks have to pay higher interest to overseas lenders.

For investors in bank shares, the considerations include further rises in interest rates that could put pressure on already heavily indebted households and lead to higher bad debts. Any problems getting money from overseas will also affect banks because they won’t be able to lend money as freely and therefore earn interest profits. This suggests banks may not be as profitable as they were prior to the global economic problems for quite some time.

Hallmarks of Success for Banks: Price-to-Book

Banks' balance sheets consist mostly of financial assets with varying degrees of liquidity.

Book value is a good proxy for the value of a banking stock.

Assuming the assets and liabilities closely approximate their reported value, the base value for a bank should be book value. For any premium above that, investors are paying for future growth and excess earnings.

Seldom do banks trade for less than book, but if they do, the bank's assets could be distressed.

Typically, big banks have traded in the two or three times book range over the past decade; regionals have often traded for less than that.

A solid bank trading at less than 2x book value is often worth a closer look. Remember, there is almost always a reason the bank is selling at a discount, so be sure you understood the risks.

On the other hand, some banks are worth 3x book value or more, but we would exercise caution before paying that much.

Bank stocks are volatile creatures, and you can find good values if you're patient - especially because even the best banks will generally be hit hard when any high-profile blowup occurs in the financial services sector.

Lying up several banks for a relative P/B valuation isn't as good as putting together a discounted cash flow model, but for this industry, it can be a reasonable approximation of the value of the business.


Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks: Strong Revenues

Above-average revenue growth: Historically, many of the best performing bank investments have been those that have proven capable of above-average revenue growth.

Wide margins have generally been elusive in a commodity industry that competes on service quality.

• But, some of the most successful banks have been able to cross-sell new services, which adds to fee income, or
• pay a slightly lower rate on deposits and charge a slightly higher rate on loans.

Keep an eye on 3 major metrics:

• 1. net interest margin
• 2. fee income as a percent of total revenues, and
• 3. fee income growth.

The net interest margin can vary widely depending on

• economic factors,
• the interest rate environment, and
• the type of business the lender focuses on,

so it's best to compare the bank you're interested in to other similar institutions.

Fee income made up 42% of bank industry revenue in 2001 and has grown at an 11.6% compound annual rate over the past 2 decades.

A large and diversified company such as Fifth Third generates more than 40% of its net revenues from fee income, whereas smaller, less diversified companies such as thrifts (e.g. Golden West) get just 10% to 12% of income from fees.

Make sure, therefore, that you're comparing similar companies and that you understand the company's strategy. As always, examine the number over a period of time to get a sense of the trend.

Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks: Net Interest Margins

Another simple measure to watch is net interest margin.

Net interest margin
= net interest income / average earning assets

Virtually all banks report net interest margins because it measures lending profitability.

There is a wide variety of net interest margins, depending on the type of lending a bank engages in.

Most banks' margins fall into the 3% - 4% range.

Track margins over time to get a feel for the trend.

If margins are rising:

• Check to see what's been happening with interest rates. (Falling rates generally push up net interest margins.)
• In addition, examine the bank's loan categories to see whether the bank has been moving into different lending areas. For example, credit card loans typically carry much higher interest rates than residential mortgages, but credit card lending is also riskier than lending money secured by a house.

Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks: Efficiency Ratios

The efficiency ratio measures non-interest expense, or operating costs, as a percentage of net revenues.

Efficiency ratio
= non-interest expense / net revenues
= operating costs / net revenues

Basically, it tells how efficiently the bank is managed.

Many good banks have efficiency ratios under 55% (lower is better).


For comparison, the average efficiency ratio of all insured institutions in the fourth quarter of 2002 was 58.4%, according to the FDIC.

Look for banks with low efficiency ratios as evidence that costs are being kept in check.


Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks: ROE and ROA

Return on Equity (ROE) and Return on Assets (ROA) are useful for gauging bank profitability.

ROE:

Investors should look for banks that can consistently generate mid- to high-teen ROE.

Investors should be concerned if a bank earns a level of ROE too far below this industry benchmark.

Ironically, investors should also be concerned if the ROE is too far above the industry benchmark too.

• Many fast-growing lenders have thrown off 30% or more ROEs just by provisioning too little for loan losses.
• Remember, it can be very easy to boost bank's earnings in the short term by underprovisioning or leveraging up the balance sheet, but this can be unduly risky over the long term.

ROA:

Besides looking for a consistent mid- to high-teen ROE, it is good to see a high level of ROA as well.

For banks, a top ROA would be in the 1.2% to 1.4% range.

Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks

What should investors look for when investing in banks and other financiers?

Because their entire business - their strengths and their opportunities - is built on risk, it's a good idea to focus on conservatively managed institutions that consistently deliver solid - but not knockout - profits. Here's a list of some major metrics to consider:

1. Strong Capital Base
2. Return on Equity and Return on Assets
3. Efficiency Ratios
4. Net Interest Margins
5. Strong Revenues
6. Price-to-Book

These metrics should serve as a starting point for seeking out quality bank stocks.

Overall, we think the best defense for investors who want to pick their own financial services stocks is patience and a healthy sense of skepticism.

Build a paper portfolio of core companies that look promising and learn the businesses over time. Get a feel for,

• the kind of lending they do,
• the way that risk is managed,
• the quality of management, and
• the amount of equity capital the bank holds.

When an opportunity presents itself - and one always does - you'll be in a much better position to act.

Ref: The Five Rules for Successful Stock Investing by Pat Dorsey


Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book