What Drives a Banks Profitability?

Value starts with earnings, so let’s break down exactly how bank’s put dinner on the table.

In this case study, we will use Citigroup (NYSE: C), Wells Fargo (NYSE: WFC), and Bank of America (NYSE: BAC) to demonstrate exactly what drives profitability.

First, let’s begin with Return on Equity (ROE), the ratio of a bank’s earnings to its capital.

ROEEquity Multiplier (Leverage)Return On Assets (ROA)

Comparing ROE for Bank of America, Wells Fargo, and Citi:

Q2 2013 ROE ROA Capital Ratio

$BAC 6.55% 0.74% 11.30%

$WFC 14.02% 1.55% 11.06%

$C 8.8% 0.89% 10.11%

All financial data sourced from Yahoo! Finance and company earnings presentations.

Wells’ outperformance in ROE is clearly driven by higher ROA. So let’s now drill down into ROA.

ROA Asset UtilizationProfit Margin

Where asset utilization measures how productive the bank’s assets are (i.e., Does $10 of assets yield $0.50 or $1?).

Comparing ROA for Bank of America, Wells Fargo, and Citi:

Q2 2013 ROA Profit Margin Asset Utilization

$BAC 0.74% 13.73% 5.39%

$WFC 1.55% 24.58% 6.29%

$C 0.89% 16.97% 5.20%

Profit margin defined here as total income (total interest income plus non interest income). Asset utilization calculated as annualized total income divided by average total assets.

Once again, the driving factor behind Wells’ outperformance is quite clear – much better profit margins and slightly better asset utilization.

The asset utilization ratios look similar in terms of the percentages; however, the 1% advantage for Wells across its $1.4 trillion in average total assets translates to a substantial advantage in raw dollars.

Let’s drill down one final time into profit margin. For banks, expenses break down into two overarching categories: interest expense and non-interest expense.

To measure interest expense on a relative basis, we will use the net interest margin. This is a measure of the difference the banks bring in from interest income on loans and interest paid out to depositors.

To gauge non-interest expense on a relative basis, we will use the efficiency ratio. This is defined as the ratio of non-interest expenses to revenue.

For this ratio, a lower ratio indicates fewer expenses per dollar of revenue. So, lower = better.

Q2 2013 Net Interest Margin Efficiency Ratio

$BAC 2.44% 76.62%

$WFC 3.46% 57.3%

$C 2.85% 59%

Once again, it’s clear to see Wells’ advantage. However, it is only now coming into focus why Citi outperformed Bank of America…

The efficiency ratio indicates that Citi is doing a better job managing non-interest expenses, which is driving its 200+ basis point ROE advantage over B of A.

Taking this systematic approach to analyzing banks is a simple and fundamentally sound method to uncovering the driving factors in company performance.

In this case, it highlighted just how strongly Wells Fargo has performed recently, and also points to the work that still needs to be done at Bank of America.