How to Analyze Banks (part 3)
How to Analyze Banks (part 3)
A deep dive into understanding why some banks are more profitable than others.
10 minute read
This is part three of the series How to Analyze Banks. In this article, we explore why a bank can be more or less profitable than others.
Qualitatively
Banks can derive competitive advantages by having lower funding costs, lower operating costs as a percentage of revenue, or specific knowledge of a business.
Lower funding costs
Having access to a large branch network can decrease funding costs for banks. A large network allows banks to offer their services to less competitive markets and a larger percentage of the population.
Another reason why a bank’s funding cost may be lower is that a bank is less aggressive in pursuing new deposits and does not pay higher rates to attract them.
Efficiency
If a bank is able to grow its loan book without investing and maintaining a large branch network, then it would have lower operating expenses as a percentage of revenue, which would translate into superior profitability.
It is also important to note that wealth concentration in small geographic areas can lead to higher efficiency because banks do not need to maintain a large branch network.
We can measure the efficiency of a bank through the cost-income ratio. This ratio compares non-interest expenses (operating expenses) with pre-provision income [1].
Specialization
By being highly specialized in a particular industry, a bank can offer superior service to customers and loan money more effectively. This translates into superior asset quality and a lower percentage of non-performing loans. Because a bank’s interest income generating capacity depends on the amount of loans it has, having a lower percentage of defaults means greater profitability because of the increase in interest income.
Government Policy
Government policy can also influence profitability through changes in interest rates, limiting competition in a market, and regulations like subsidized lending and interest rate caps.
Based on the above, the following are critical questions that can point to the existence of a competitive advantage:
What is the bank’s geographic franchise?
What is its business focus?
In what sectors does it generate the bulk of its earnings?
Who are the bank’s customers?
What is the nature of the bank’s customer (borrower) and depositor base?
Big companies? Government or nonprivate organizations? SMEs? Consumers?
What is the bank’s position within its market?
How big is the bank?
Where does it stand within the applicable banking sector?
Is it one of the top three banks in the market?
Is it a middle-market bank or a local community-based institution?
Quantitatively
Diving deeper
To understand why a bank’s profitability varies between competitors, it is also important to understand, quantitatively, why a bank can lend more profitably than another, or why performance has changed over time. To do this, it is useful to look at changes in interest income, interest expense, net interest income, non-interest income, pre-provision income, loan-loss provisions, net operating profit after provisions, pre-tax profit, cost of funding, and yield.
Cost of funding = interest expense / interest-bearing liabilities
Gross Yield = interest income / interest-earning assets
Net interest spread = gross yield - the cost of funding
Finally, based on the data we can ask the following questions:
How does the current figure compare with the previous period?
How does the percentage change compare with historical performance over the past two or three years?
Is this the continuation of a trend, or possibly the reversal or beginning of one?
How do these figures compare to the bank’s peers?
Depending upon whether the change is sector-wide or bank-specific, what might have caused the change?
Notes
[1] A bank’s operating income comes from two sources: net interest income and non-interest income. When operating expenses are deducted from operating income, what is left is an important line item called pre-provision income. Pre-provision represents the income that, subject to certain deductions like taxes, is available to restore and maintain or improve a bank’s financial health.