Minyan Mailbag: Bank Earnings 101
Many people are unaware that banks are generally leveraged 10:1.
Minyan Peter, who has become quite popular around the 'Ville with readers and professors alike beginning with his first letter, A Bird's-Eye View of the Credit Conundrum, writes in again on the basics of bank earnings.
3Q earnings reports for the banking sector are just about a month away. Given the significance of financials to the performance of the S&P 500, and the attention I expect banking results to get, I wanted to help the Minyanville community understand some of the basic underlying dynamics of bank earnings.
To do this, I am going to use Bank of America's (BAC) 2006 annual results; however, everything I am going to describe is broadly applicable to other major banks.
But first a pop quiz:
On its approximately $1.46 trln of average assets, how much did BofA earn last year?
a. $84 bln
b. $42 bln
c. $21 bln or
d. $10.5 bln
Now take your answer and express it as a % of BofA's average assets.
a. $84 bln = 5.76%
b. $42 bln = 2.88%
c. $21 bln = 1.44% or
d. $10.5 bln = 0.72%
And one final question: How much shareholders' capital did BofA have at the end of 2006?
a. $540 bln
b. $270 bln
c. $135 bln or
c. $67.5 bln
The correct answer for each question is "c". BofA earned $21.1 bln, representing 1.44% of average assets used, $135 bln of shareholders' capital.
From experience, I have found that most people are surprised to learn that banks' net income is generally only between 1 and 2% on assets. And many people are also unaware that banks are generally leveraged 10:1.
So why are these points important?
First, small changes in interest rates and loan losses have a big effect on bank earnings. For example, in 2006, BofA had 70 basis points of loan losses, but in 2002 that figure was 110 basis points – a 40 bps difference. All things being equal, (and ignoring income taxes for simplicity) if we applied BofA's 2002 level rate to its 2006 results, earnings would have been 28% lower.
Further, given that borrowing spreads and loan losses are highly correlated (you pay more when your portfolio is of lesser and lesser quality) a 40 basis point increase in losses could also bring with it a 25 basis point increase in funding costs. So, going back to my example, if we applied both the 40 basis point increase in losses and a 25 basis point increase in funding costs, BofA's earnings would have dropped by 45%.
Now while it takes time for higher losses and funding costs to flow all the way through to the bottom line (not all debt rolls over at once; nor do all bad credits charge off at once), I hope you can see by this example why the financial services community is so fixated on Federal Reserve interest rate cuts. By dropping short term interest rates, the Federal Reserve helps to offset the impact of higher borrowing spreads and loan losses. The difference between and a 25 and 50 basis point cut may not feel like much to you, but when all you're earning at best is 1-2% on assets, it is a huge deal.
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