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Banking Industry Primer

The Business of Banking

Banks are intermediaries for capital and hold the risk or underwrite when this dynamic is not perfectly balanced. Historically, the commercial banking and investment banking functions have been separated by law – these restrictions have since been repealed and larger banks tend to take on capital markets operations due to the complimentary nature of the businesses.

For traditional commercial banking, borrowers (individuals or organizations that require loans) are matched with lenders (depositors or purchasers of income certificates). The bank is a function of risk pooling credit. Whenever money is lent out, there is a risk of loss. As the counterparty of the borrower and the lender both are the bank, the bank indemnifies the depositor from the risk of loss.

The risk of loss and burdensome nature of due diligence (evaluating the creditworthiness of the counterparty) make it impractical for the everyday person or organization to be making bilateral loans. The bank takes deposits and lends out to businesses with an acceptable loss ratio that makes the aggregate loanbook profitable despite individual loans failing. As the bank takes the risk, it is said to be underwriting the loans.

Investment banks have themselves been split between capital markets and corporate finance (also known as investment banking). For pure investment banking advisory, usually in the realm of mergers & acquisitions, spin-offs and divestitures, this was a fee generating business that did not require underwriting risk – however, similar to commercial real estate, the fee was effectively for brokering a deal.

The underwriting of securities such as debt or equity would however – and bankers would similarly be the bridge between capital and organizations that required it. The sales & trading function is one where the investment bank operates as a market maker on secondary markets. When an entity looks to buy or sell, the investment bank offers a price, looking to offload on the other end. Like other aspects of banking, this is the brokerage component.

Today, most universal banks are diversified financial institutions with operations beyond the scope of normal banking. Today’s global banking organization may have a business mix more reflective of the following:

  1. Personal & Commercial Banking (or Retail/Commercial) – This will be the main focus of this section
  2. Capital Markets (or Wholesale Banking)
  3. Wealth Management – Wealth management is heavily favored today in bank strategy due to low capital requirements for wealth management – the business model is covered in Asset Management
  4. Insurance

Bank Income Statement

On the income statement, banks register net interest income and non-interest income to get to revenue. Interest income is earned when the bank collects interest on assets loaned out (which are funded by liabilities). Non-interest income includes transaction fees, account fees, servicing fees, credit card usage fees and fees related to mutual funds (trailer and management expenses are sometimes booked to wealth management revenues).

Interest Income

Banks lend money to individuals, businesses, organizations and governments through a variety of loans (discussed in our commercial banking section) and collect interest on the loan. What the interest rate will be is a function of the bank’s relationship with the counterparty, size, tenor, credit risk, and security.

For banks to lend money out, funding is required. The cheapest form of funding is deposits (particularly retail and small business deposits). These accounts pay little to no interest and are fairly “sticky” – so banks will fight for deposits. Retail deposits are where the bank captures the highest spread for a longer-term loan.

Banks also offer a variety of other earning products, including Guaranteed Income Certificates (GICs) where customers can lock in returns. These are higher interest, but banks have the benefit of knowing the tenor with precision. For incremental loans after cheaper funding has been exhausted, banks will turn to wholesale funding (where duration will be more closely matched to that of the loan). For instance, if the bank sells a 5-year mortgage, it will source 5-year funding.

All lenders care about interest income, but banks have to weigh profitability against capital. Though mortgages do not necessarily constitute high returning assets on an economic basis, they do not eat up any capital due to the safety of the product with implicit government guarantees (although this may change due to recent tightening initiatives by the federal government in Canada).

Non-interest Income

Banks collect a variety of fees from accounts (monthly fees for chequing and savings accounts with varying tiers depending on levels of service – unlimited withdrawals, use of ATMs, etc.), transactions (ATM withdrawal, overdraft charges), credit cards (a percentage charge for use to the vendor, annual fees for special cards), and various other products. If recurring, these are seen as good revenues as they have ancillary revenue potentials (banks can bundle and cross-sell) and do not put pressure on the bank’s capital (no capital has to be held against these revenues).

Credit card usage is distinct in Canada, and penetration is dominated by banks (vs in the US where every Costco and Lowes will have some offer). Credit cards are primarily used as a transaction facilitator rather than as a lending vehicle – whereas in the US, credit cards may be seen as a working capital loan (accordingly, interest rates on credit card average a lot lower than in Canada). Credit card debt in Canada comes with steep interest rates and serves as a profitable product for banks.

Provisions for Credit Losses

There is default risk inherent in lending (if there was no risk, there would not be a profitable interest margin), so a certain amount of loans will go bad and become uncollectable. This allowance is a deduction on the income statement.

Asset and Liability Matching

Banks must match the duration risk of assets and liabilities to negate interest rate risk. Liabilities (funding via deposits) is usually shorter duration than assets (loans), which means that the bank’s surplus (excess of assets to liabilities) will often be put into short duration financial instruments to immunize the portfolio. As such, higher interest rates are to the benefit of banks.

Asset-Liability Management, Funding and the Loan Mix

Banks have huge balance sheets well in excess of their equity value due to all deposits being liabilities – the balance sheet is the business. Banks hold a lot of cash as well – a figure that can be substantial enough to push enterprise value to a negative number (enterprise value = debt + equity + preferred shares – cash + minority interest).

Due to banking being an industry that all consumers need to have access to for societal stability (for putting their money), banks are heavily regulated and deposits are insured up to $100,000 by the government. As the government would prefer to not have to step in, banks have very tight restrictions on what assets they can hold with customer deposits.

Banks will have very strict asset-liability management limits. Banks will have a certain amount of assets that they hold (mortgages, bonds, personal loans, auto loans, securitized instruments) versus their liabilities (deposits, bonds). Assets should exceed liabilities and the surplus/cushion should be in short-term liabilities that are cash like (short term bonds, commercial paper) that will bring down the total duration of assets.

This is because the duration of the assets must match the duration of liabilities for the bank to be insensitive to changes in their net asset position when interest rates move. If assets move more than liabilities when interest rates rise, this will cause the bank to have a smaller cushion. If liabilities move more than assets when interest rates fall, this will also cause the bank to have a smaller cushion. Matching liabilities with assets and rebalancing when interest rates change is important in ensuring that a bank does not see fluctuations that are unrelated to the operating business.

Banks are intermediaries – they are looking to borrow money and lend it back out a higher rate.

The best source of funds is deposits because interest rates as the interest rate paid out to depositors is zero or close to zero. In Europe, there are certain banks that charge depositors for the right to deposit as depositing is a service. The downside with deposits is that they can be withdrawn on demand, which means that banks are exposed to running out of liquidity if there is a loss of confidence in the banking system (which is a reason why deposits are insured).

Certain deposit accounts (savings accounts) are stickier, and accordingly, require a higher interest rate. Banks will price loans based on a required return on capital for the marginal loan – that is the most expensive cost of funds.

For instance, if a homeowner takes on a 5-year loan, the bank will charge a spread to the cost of funding this loan on the wholesale market (possibly selling a 5-year government bond, so that assets match liabilities). If the government bond is 1%, the bank may charge 2%, capturing the 1% spread. However, if the bank has sufficient deposits, the spread is the entire 2%.

Of course, the duration of the 5-year loan is 5 years (this is the asset from the bank’s perspective) and the duration of the deposits is zero (the liability from the bank’s perspective), there is a mismatch in duration that needs to be balanced by the bank’s excess capital being held in very short term securities.

Valuation of Banks

In the current market environment, banks should be viewed as financial services conglomerates instead of traditional lenders only.

Valuation multiples for banks are influenced by their loan mix and geography. An attractive bank has a very large number of depositors and has good access to wholesale funding markets – but does not need to use it.

The loan mix is also key. Higher risk loans offer higher interest rates, but the actual risk calculated by the bank depends on how much capital they put up against the loans. Loan risk can be lowered substantially through collateral or insurance, both of which are evident in mortgages. As such, mortgages are very low returning assets for banks on a cash basis but very attractive from a capital basis.

Strong growth in safe loans with strong interest rates means that a bank’s prospects are good. Being in a high growth market that is business friendly is also a plus.

Some common valuation methods for banks are:

  1. Price/Earnings
  2. Price/Book
  3. Dividend Discount Model
  4. Dividend Yield

Price/Earnings

Both banks and insurers should not be valued through traditional pre-leverage metrics such as EV vs EBITDA, because liabilities are not necessarily looked at from a capital structure perspective, but as a funding source.

In essence, certain forms of debt may be viewed functionally as PP&E (although it would not ever be called PP&E) and interest may be viewed as “cost of goods sold”. As such, equity focused valuation metrics such as P/E and P/B will be standard for analysing financials.

The perceived quality of earnings will affect bank P/E multiples in a sum-of-the-parts valuation, as wealth management will be assigned the highest multiple (reoccurring fee based revenue that does not require the bank to hold any capital against it), while capital markets revenue is assigned the lowest multiple (investment banking and sales & trading revenues are perceived to be more volatile and opaque).

Price/Book Value of Equity

Price to book is better for traditional lending operations as it reflects what the market feels the bank is doing with its assets (in lending operations, banks earn a return on loans, which are assets). Price to book is usually influenced by perceived returns on assets going forward.

With the diversification of business lines and growth in capital markets, wealth management and insurance segments, P/B has become less relevant. However, P/B is still a useful secondary measure and the only reasonable measure when earnings are abnormally low or negative.

Related Reading for Banks

Financial InstitutionsAsset Management Trends · Financial Institutions Group in Canada · Investment Banking in Canada · Private Equity in Canada · Corporate Banking and Loan Syndications in Canada · Shadow Banking in China ·

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