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

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: 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