Most people have an intuitive understanding of how banks money given their daily interactions with it. In this post, we are going to break it down for investors so that they can better analyze the financials.
The biggest money maker – net interest income
At their heart, banks are quite easy to understand and most people do have an understanding of how they work.
Let me use a simple analogy. Imagine you were a money lender – lending money out at let’s say 10%. In order to raise the money that you lend out, you borrow it from your family who trusts you at 5%.
The difference between your cost of borrowing from your family, and the money you lend out is 5% – which represents your spread between the two.
Banks function quite similarly.
Their “borrowing cost” is dictated by bank deposits and money they raised from the markets (bonds, preference shares), and the money they earn is derived from the interest they get from loaning this money out.
The difference between the interest they pay and the income they generate from interest on their loans is known as net interest income.
Net interest income = Interest income – interest expense
Net Interest Margins
We use net interest margin as a a measure of profitability relative to their loan book (i.e. total loans).
For example, if you were to make a net interest income of $1 on a $100 loan, your net interest margin would be 1%.
If you were to make a higher net interest income of $2 on a $100 loan, your net interest margin would be 2%.
The higher the net interest margin – the more profitable a bank is.
Net interest margins (also known as NIMs) for banks work exactly the same way (except with more zeros at the back of course).
As interest rates start to revert back to normalized levels – net interest margins are also starting to trend up.
The market expectation is that this will continue into next year as the Federal Reserve continues to hike interest rates – something that bodes well for banks considering the importance of net interest margins to them.
Equally important – non interest income
Non interest income is exactly like what it sounds like – income generated from other activities such as credit card fees, unit trusts etc.
Although not as large in magnitude than interest income – these profit lines were extremely important to the banks when interest rates were compressed at artificial levels posts 2008 Great Financial Crisis.
Understanding what drives the top line of banks is useful in understanding their financial performance.
In the next article, we will be talking about non-performing loans and provisioning. We will also highlight why this is one of the most important things that people miss out and that catches them off-guard during a market downturn.