How Banks Make Money

Banking Profits and Bank Capital Requirements

Many of us own shares of banks and it’s pretty safe to say that all of us are bank customers. Let’s take a look at how a bank makes money by lending money.

The following is a simplified balance sheet for a bank that takes in deposits and makes loans.

Assets ($ millions) Liabilities and Equity ($ millions)
Cash on hand   $40 Customer Deposits  $900
Government T-bills and Bonds (this is money loaned to the government)   $200 Bonds Issued Capital $20
Loans & Mortgages Owed by Customers  $760 Preferred Shares  Capital $10
Share Holders’ Common Equity Capital  $70
Total Assets  $1000 Total Liabilities & Equity   $1000

The bank, of course, makes money by loaning out money.

Let’s think about how, for example, the bank can make money lending out mortgage money. Today, the going rate on a Canadian mortgage is roughly 2.0% to 2.5%.

Despite such low lending rates banks often manage to make more like a 14% return on their share holders’ equity capital. They do this through leverage.

The bank illustrated above has $1000 million dollars of interest-earning assets and yet its share owners have only invested $70 million dollars of equity capital. This bank is not primary lending out its own share owners’ money. Instead, it is primarily loaning out its depositors’ money as well as a small mount of money it raised by issuing bonds and by issuing preferred shares. In the example here, the bank has leveraged the investment of its common share owners by 1000 / 70 or 14.3 times.

A key fact that allows banks to make high returns while lending mortgage money at just 2.5% is the fact that they currently pay little or nothing on most deposits. In addition, most of their mortgage lending results in zero loan losses because most mortgages are insured against default by a government mortgage default insurance company or program. And, the customer and not the bank pays the insurance premium through an upfront fee added to the mortgage amount.

Banks are able to attract deposit money while paying little or no interest on the deposits for reasons that include the fact that every adult and every corporation requires one or more bank accounts. Also most bank deposits are insured against bank failures by a government Deposit Insurance Corporation.

It’s easy to see that if you can take money in at 0% and lend it out at 2.5%, then a lot of money can be made. The difference between the lending rate and the amount paid on deposits is known as the “spread” or Net Interest Margin (NIM) and in this case it is 2.5% minus 0%, or 2.5%. In this scenario, the bank’s gross profit would be limited only by its ability to attract and keep deposits and to find customers willing to borrow money.

In this government-insured mortgage lending business the bank’s management might be tempted, if allowed, to leverage even more than the 14.3 times mentioned just above. In fact, bank regulations allow very high, perhaps even unlimited leverage, on government-insured mortgage loans. There are also regulations regarding the overall leverage of the bank. But the insured mortgage lending business is likely to be very highly leveraged. The same rules and very high or even unlimited leverage apply to investing in government debt (which is effectively lending to government) and which typically earns the bank far less than even 2.5%.

Banks also have the ability to earn a higher spread, or Net Interest Margin, by lending for things such as automobiles or for credit card purchases or by lending to businesses. However, there is no default insurance available for lending other than for residential mortgage lending. For these loans the bank faces default risk. Typically, some small percentage of borrowers will default on their loans. Even after collection efforts and seizing any collateral, banks usually face some small percentage of loan losses on their non-insured lending.

In this non-insured type of lending a prudent bank management will not allow the leverage to get too high. And bank regulations also limit the leverage. In Canada, figures from Canadian Western Bank appear to indicate that common equity leverage of about 10 times is allowed on business loans. The overall average common equity leverage allowed is 14.3 times. That is, risk-weighted assets are allowed to be as much as 14.3 times higher than the common equity level. An additional regulation requires the banks to have additional capital which can include bonds and preferred shares, so that the overall leverage of investor capital is limited to 10.5 times.

Bank capital (leverage) regulations are designed to protect depositors’ money. The extent that a bank can leverage its owners’ capital is regulated and also depends on the types of assets, such as loans, in which the bank invests its customers’ deposits and its owners’ capital. The assets are risk-weighted. Some assets including some government insured mortgages and some government debt are considered risk-free and are weighted at a factor of zero. Some other assets are weighted at figures considerably higher than 1.

Bank capital or leverage regulations usually prevent banks from engaging in risks (loans, investments and leverage) that could threaten their ability to protect depositors’ money. Normally the risk to preferred share and bond investors is also very low. The risk that a bank will become insolvent causing a loss of share owner capital is generally very low but is not zero. And bank capital regulations certainly do not prevent banks from incurring losses in certain years or from generating inadequate profits over a period of years. If a bank runs into financial trouble it is common share owners who should expect to incur losses. Only in the event that common shareholders are “wiped out” in a bank failure should bond and preferred share investors expect to incur a loss in that situation. If the financial troubles were so severe that all investor capital was “wiped out” then depositor money could also be lost, except that government deposit guarantee programs would protect most depositors up to certain limits. Bank capital leverage and risk-weighted asset rules are designed such that severe financial distress and failure for banks should not occur. But the rules cannot totally protect against all scenarios. Also, even while bankruptcies of banks may be rare, the market value of bank common shares and also (to a lesser extent) preferred shares and bank debt can fluctuate greatly in the market.

So, banks make money for their share owners by leveraging their common equity capital. But the leverage is limited by prudency and by regulation.

The manner in which each dollar of equity capital is leveraged and loaned out determines the banks gross profitability before considering its operating costs. As a hypothetical example, a dollar loaned on a mortgage loan with a spread of 2.0% leveraged 20 times results in a higher gross profit on equity (40% before internal costs or income taxes) than a business loan with a spread of 3.0% leveraged the allowed ten times.

The above discussion is meant to illustrate some of the workings of how a bank makes money. It is not meant to be the whole story as it does not address bank fees or bank operating costs. It is meant to be a simplified explanation of the overall manner in which banks leverage owners’ equity capital to (usually) make high returns on equity for their owners. And many of us are those owners or can become owners.

END

October 25, 2015 (with minor edits to November 28, 2015)

Shawn C. Allen, CFA
President, InvestorsFriend Inc.

One of our newsletters also addressed how banks work and how they got in trouble in 2008.