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 small 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 under 2.0%.
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 2.0% or even less is the fact that they currently pay little or nothing on much of their 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. The great majority of economic activity by consumers takes place by transferring money from a consumer’s bank account to the bank account of some corporation or other. Much of this occurs electronically. Banks can attract deposits at low rates because it is convenient end even necessary for consumers and businesses to hold money in bank accounts. It’s also safe since most bank deposits are insured against bank failures by a government Deposit Insurance Corporation.
It’s easy to see that if you can take in money that is not your own at 0% and lend it out at even just 2.0%, 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 2.0% minus 0%, or 2.0%. In this scenario, the bank’s gross profit would be limited mostly by its ability to attract and keep deposits and to find credit-worthy customers willing to borrow money.
In this government-insured mortgage lending business the bank’s leverage is more than the 14.3 times mentioned just above. In fact, bank regulations allow very high, even unlimited leverage, on government-insured mortgage loans. There are also regulations regarding the overall leverage of the bank. 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 2.0%.
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. See below for a real-life example of the allowed leverage for Canadian Western Bank.
Bank capital (leverage) regulations are designed to protect depositors’ money. The extent that a bank can leverage its owners’ capital by lending out depositor’s money 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 highly 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 losses to bad loans and its operating costs. As a hypothetical example, a dollar loaned on an insured mortgage loan with a spread of 2.0% leveraged 20 times results in a higher gross profit on equity (40% before internal costs and income taxes) than a business loan with a spread of 3.0% leveraged ten times (30% before loan losses, operating costs and income tax).
The above discussion is meant to illustrate some of the workings of how a pure lending bank makes money. Large banks have non-lending operations including wealth management and assisting large companies to issue bonds and stocks. Those operations are not included in the simple example above. 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.
October 25, 2015 (with minor edits to December 13, 2020)
Shawn C. Allen, CFA
President, InvestorsFriend Inc.
A real life example:
Below are some facts and figures from Canadian Western Bank as of its October 31, 2020 year end. CWB is largely a pure lending bank although it also has some wealth management and Trust operations.
CWB paid an average of 1.9% on its deposits in 2020. It’s average interest rate on loans was 3.8% for personal loans and 4.8% for commercial loans. Its overall average interest rate on loans was 4.6%. This leads to a net interest margin of 2.7%. Overall when accounting for its cash and securities assets and accounting for its equity capital upon which it does not pay interest, CWB’s overall net interest margin was 2.45%. Note that the great majority of its personal loans are mortgages and are categorized as Alternative mortgages and are not the type of mortgages that have rates below 2%.
CWB had physical cash and non-interest bearing deposits in other financial institutions of $114 million. This amounts to just 0.4% of its total deposits. Since this includes deposits with other financial institutions, it’s interesting to consider what a very tiny percentage indeed of customer deposits exist as physical cash in the bank’s various vaults. CWB earns no interest on this cash and is therefore incented to minimize it.
In addition it had $254 million of interest bearing deposits with other financial institutions for a total of $368 million of total cash resources. This amounted to only 1.3% of total deposits. Clearly, CWB is confident that only a very tiny portion of its customers’ deposits will be withdrawn in the very near term. But just in case there was ever a large outflow of deposits CWB also has an additional $3,225 million invested in highly liquid bonds that can be converted almost instantly to cash. This amounted to 11.8% of deposits. The total cash and liquid assets amounted to 13.2% of total deposits.
Banks strive to make double digit ROEs on loans and assets that mostly earn low single-digit returns. They do this through leverage. That is, they try to make loans with or buy bonds with a maximum amount of depositor money and a minimum amount of their own investor’s equity and bond capital. The result is that they treat their owners’ capital as a scarce resource. In order to protect depositors, bank regulators set some limits on the minimum amount of owner capital that the banks must invest in various categories of loans and other bonds and assets on their balance sheet.
Canadian Western Bank is subject to having a minimum overall common equity ratio of 7.0% of risk-weighted assets and total owner capital (including bonds and preferred shares issued by CWB) of 10.5%.
The fact that assets are risk-weighted is very important as the following demonstrates.
Most of CWB’s bonds that are issued by Canada or the provinces are rated at 0% risk. A modest portion of CWB’s residential mortgages (presumably fully insured by CMHC or equivalent) are also rated at 0% risk. CWB can issue these mortgages and purchase these bonds and fund them strictly with depositor money without using up any of their own owner’s capital. The bond assets likely earn no more than 1.5% and the highest quality mortgages may only earn about 2% (especially after paying broker commissions on origination) but if they can be funded entirely by the lowest cost deposits then CWB can still earn a positive spread. And there would be very little administrative or other costs associated with investing in the government bonds.
Most of CWB’s residential mortgages are risk-rated at 35%. This means that CWB must effectively fund these with a minimum of 7% x 0.35 = 2.45% common equity and 10.5% x 0.35 = 3.675% total owner’s capital with the rest funded by deposits. In this way a 1% spread over the cost of deposits can be leveraged up to a 1%/0.0245 = 41% return on common equity – before the cost of bad loans and all administrative and other non-interest costs and taxes.
About 80% of CWB’s loans are commercial as opposed to personal loans and these represent about 60% of CWB’s assets and are risk-rated at 100%. That means that CWB must fund these loans with a minimum of 7% common equity and 10.5% total capital and the remaining 89.5% can be funded with deposits. If CWB wants to make say a 21% return on equity on these loans before the cost of bad loans and before administrative costs and all other non-interest costs and taxes then it must charge 3.0% more than its costs of deposits.
The above illustrates why banks must charge higher interest rates to commercial borrowers. It’s because the risks are higher and therefore less leverage is appropriate and allowed.
December 13, 2020