Banking explained - Part 1

The Romans did more than popularise bloodsports and central heating. They also pioneered a banking network that extended throughout much of Europe, Asia and parts of Africa. Jesus, as we now know, didn't think much of it and bankers have been suffering from low self-esteem ever since.

But that hasn't stopped many subscribers from buying bank shares. Most investors own either a regional banking stock or one of the big four, and many own both.

So, to give you a better understanding of their attractions as an investment, we're going to explain over the coming issues what drives a bank's profit.

Banking basics

The basics of banking haven't changed much since Jesus threw the moneychangers out of the temple. Banks take your money, paying you a rate of interest for the privilege, and lend it out at a higher rate. Assuming they get it back, the difference is how they make their money. But before explaining this measure, let's look at a typical bank's structure.

We all know about retail banking, where the products consist of home loans, credit cards, personal loans and priority and private banking. Irritating queues and broken ATMs are also among the product offerings.

Business banking usually concerns small to medium sized businesses, typically with needs of less than $50m, with larger clients handled by corporate or institutional banking.

Finally, one of the most rapidly growing area of a bank's activities is wealth management. This area handles funds management, financial planning and trustee services on behalf of clients.

The biggest and most recent change in the way that banks have operated has occurred with the switch from relying on interest margins to fee income.

The growth in fee income has been one of the main spurs for banking profitability over the past decade. In fact, such has been the magnitude of this growth that many analysts believe that it can't possibly continue. Let's examine this first.

A decade ago net interest income – the amount left after deducting the interest a bank pays to depositors for money borrowed from the interest earned on its lending – dwarfed the income from fees. But fee income is catching up fast. And it's had to.

Profit driver

That's because the net interest margin, a bank's traditional profit driver, has been declining.

This measures the difference in interest rates between what the bank lends money out at and what it pays depositors. For example, if a bank borrows at 5% and lends at 7%, its net interest margin is 2%.

As a result of increased competition, especially from non-bank lenders, this margin has been falling but the growth in fee income has more than compensated. But whenever the net interest margin figure drops by a few basis points (one hundredth of one percent), many analysts claim that this is a prelude to the end of the huge profitability of the banks.

We think that's a bit extreme. If the margin were to fall spectacularly we would be more concerned but, at this stage, there's still scope for further fee growth. And we may well find that if things become too tough, the cartel-like nature of the big banks would deliver a drop in activity deemed too competitive.

The other main driver of bank profits is the quality of the loan book. If you're lending to people who are unlikely to pay it back, your profitability can evaporate.

Disclosure

Nowadays, more enlightened disclosure means that you get more than the total dollar amount of a bank's loans. This helps in early detection of a bank holding a lot of assets in a dud sector, as with ANZ and its United States telecoms loans (see issue 121/Feb 03 ).

When analysing the loan book, the key numbers to look at are bad debts and the provisions for bad debts. When a loan gets to the stage where the bank realises it won't collect any more funds, the amount is written off as a bad debt.

Doubtful debts are ones where the bank has identified a loan that is likely to be written off, either partly or in full, and sets aside an amount to cover any loss. But the banks have billion dollar loans books with bad debts just waiting to happen. For this they estimate a general provision for doubtful debts.

To provide a comparison with competitors, banks normally provide provisions as a percentage of total assets or risk adjusted assets (a concept that we'll explain next issue). It's a bit of a double-edged sword. While a low figure suggests management is doing a good job, it also means that there isn't a lot of fat left if things go wrong.

So, these are a bank's two main profit drivers. in Part 2 we'll delve into the mysteries of a bank's balance sheet.

Bet you can't wait.