Bank Revenue Sources

• Banks generate revenue through net interest income, which typically makes up 50-75% of their revenues.
• Net interest income is the interest earned on assets like loans and securities, minus what's paid on liabilities like deposits.
• Banks seek to pay low interest on deposits and make loans at higher rates to maximize net interest income.
• Wholesale funding from other financial institutions, the government, and capital markets also allows banks to fund lending.
• Non-interest income makes up about 25-50% of a bank's revenues.
• Non-interest income primarily includes fees:
• Investment banking advisory fees
• Commercial banking lending and deposit fees (e.g., ATM fees)
• Asset management fees
• Credit card fees (e.g., interchange fees).
• A bank's income statement starts with interest income, then subtracts interest expense to get net interest income.
• Non-interest income is added to net interest income to find total revenues.
• Subtracting non-interest expense from total revenues gives pre-tax, pre-provision income.
• Credit loss provisions are then subtracted to arrive at pre-tax income, followed by taxes to finally get net income.
• Non-interest expense is often SG&A (selling, general, and administrative expenses).
• Credit loss provisions are an estimate of losses for loans during the period.
• Banks must allocate capital to match estimated losses.

Key Profitability Ratios

• Net Interest Margin (NIM) = Net Interest Income / Average Earning Assets
• NIM measures how effectively a bank uses assets to generate income.
• Efficiency Ratio = Non-Interest Expense / Net Revenues
• The efficiency ratio measures operational efficiency.
• Return on Assets (ROA) = Net Income / Average Assets
• Return on Equity (ROE) = Net Income / Average Common Equity

Loan Loss Reserves (LLRs)

• LLRs are a buffer to absorb expected losses in a bank's loan portfolio.
• LLRs are considered a contra-asset.

Loan Loss Reserve Calculation

• Beginning of Period (BOP) Loan Loss Reserve
• Less: Net Charge-Offs
• Plus: Credit Loss Provisions
• Equals: End of Period (EOP) Loan Loss Reserves
• When a borrower stops loan repayment, the bank accrues interest until 90 days past due.
• After 90 days a loan is considered a Non-Performing Loan (NPL) and goes to non-accrual.
• Net Charge-Offs (NCOs) are realized losses on NPLs.
• NPLs are appraised based on the collateral value and borrower's ability to repay.
• Gross charge-offs represent write downs
• Net Charge Offs = Gross Charge-Offs - Recoveries

Asset Quality Ratios

• Non-Performing Loan (NPL) Ratio = NPLs / Total Loans
• Measures the proportion of loans classified as non-performing.
• Net Charge-Off (NCO) Ratio = NCO / Average Total Loans
• Measures the amount of loan losses.
• Loan Loss Reserve (LLR) Ratio = LLRs / Total Loans
• Measures the proportion of a bank's loans covered by loss reserves. Bank regulators use capital ratios to assess a bank's solvency.

Capital

• Capital refers to sources of funding for banks and is divided into tiers based on safety.
• Tier I Capital includes:
• Tangible Common Equity (TCE): Equity less goodwill and intangibles.
• Preferred Stock
• Trust Preferred Securities (TRUPS): Hybrid security used by banks.
• Tier II Capital includes:
• Loan Loss Reserves (LLRs)
• Subordinated Debt
• Tangible Assets (TA) are total assets less goodwill and intangibles.
• They include assets recoverable in bankruptcy.
• Risk-Weighted Assets (RWA) are weighted based on risk level:
• Cash = 0%
• Treasury securities = 20%
• Commercial loans and ABS/MBS = 100%
• Assets can be rated higher than 100% if their value is below investment grade (BB).

Capital Adequacy Ratios

• Tangible Equity Ratio = (TCE + PS) / TA
• Tangible Common Equity Ratio (TCE) = (TCE) / TA
• Indicates how much losses a bank can take before shareholder equity is depleted.

Regulatory Ratios

• Regulatory ratios are used by bank regulators to capture risk differences between asset classes.
• Tier 1 Common Capital = (TCE) / RWA
• Tier 1 Risk-Based Capital = (TCE + PS + TRUPS) / RWA
• Tier 1 Leverage = (TCE + PS + TRUPS) / ATA
• Total Risk-Based Capital = (TCE + PS + TRUPS + LLRs + SD) / RWA
• Banks are valued on cash flows to shareholders because debt funding is linked to assets and profitability.
• Banks trade based on Tangible Book Value and Earnings.
• Price/Tangible Book Value (P/TBV)
• Price/Earnings (P/E)

Net Interest Income (NII)

• The difference between interest earned on a bank's earning assets (loans, securities) and the funding cost of its liabilities (deposits, borrowings).
• NII is typically two-thirds of bank revenues.
• Drivers of NII:
  • Volume of assets
• Spreads on those assets (NIM)
• Net Interest Margin (NIM) is the spread between interest earned on assets and the interest cost of liabilities.
• NIM = NII / Average Earning Assets

Factors Affecting NIM

• Asset Yields:
• Asset mix (loans vs. securities)
• Credit riskiness
• Duration
• Liquidity
• Funding Costs:
• Funding mix (low cost deposits vs. wholesale funding/long-term debt)
• Duration of funding (CDs/long-term debt vs. demand deposit/short-term funding)
• Perceived financial risk of the bank
• Level of deposit competition
• Capital Levels:
• Higher common equity benefits NIM due to the lack of interest expense though it will lower ROEs.
• Loans typically have a higher margin than securities, but require higher operating costs (employee compensation).
• Loan portfolios typically make up the largest asset class on a balance sheet, at nearly 60% of assets.

Real Estate Loans

• Real Estate Loans Make Up A Large Portion of The Average Bank's Loan Portfolio
• Residential Mortgages:
• Residential Mortgages account for ~20% of total loans.
• Home Equity Lines of Credit (HELOCs):
• Secured loans backed by a home's value minus outstanding mortgage balance.
• HELOCs typically account for ~5% of total loans.
• Commercial Real Estate:
• Range between ~10-15% for larger banks but can be up to ~40% for smaller banks.
• Commercial & Industrial (C&I) loans to businesses make up about ~20% of a typical portfolio.
• Consumer loans, to individuals not secured by real estate, are about ~20%.
• Securities make up around 20% of bank assets.
• Securities are used as a source of liquidity and for asset-liability management.
• Banks hold more securities when deposit growth outpaces loan demand, boosting short-term profitability but increasing interest rate risk.
• Securities may include U.S. Treasuries, MBS, etc.

Deposits

• Deposits are the primary liability on a bank’s balance sheet, making up about 75% of all funding.
• Deposit include:
• Demand deposits (interest-free checking)
• Savings/money market deposits (interest-yielding)
• CDs/time deposits
• Noninterest-bearing deposits make up ~30% of total deposits, savings/money market ~60%, and CDs/time deposits ~10%.
• Noninterest Income is Fee revenue, and is ~ of bank revenues.
• Larger banks have a larger percentage of revenues, while smaller banks rely on NII.

Fee Sources

• Deposit service charges
• Includes overdraft and non-sufficient fund (NSF) fees
• Also includes ATM charge
• Mortgage revenues:
• Origination fees
• Card/payments:
• Debit/credit, interchange, foreign transaction, and other transaction fees
• Wealth Management
• Insurance
• Capital Markets:
• Loan syndications and underwriting, investment banking, sales/trading activities
• Noninterest Expenses are not related to funding or interest costs, and include:
• Personnel costs, marketing, professional services, technology, etc.
• Efficiency Ratio = Noninterest Expense / Total Revenue
• Banks measure NIMs to understand the relationship between interest rates and bank stocks.
• The makeup and duration of a bank's balance sheet impact its earnings with changes in interest rates.
• Banks can be asset sensitive if their asset base is shorter in duration than its liabilities, in these cases assets will re-price to higher rates faster.
• Conversely, banks can be liability sensitive if their asset base is longer, liabilities will re-price to higher rates faster.

Loan Yields

• Loan yields are generally derived from a market interest rate, its maturity, and its risk profile.
• Some loans are fixed rate, and some are variable.
• Loans priced off short-term rates include C&I, construction, home equity, and credit cards.
• Auto loans are priced off 2-3 year rates, commercial mortgages at 5 years, and residential mortgages at 10-year Treasury rates.
• A deposit mix determines how much deposits reprice to interest rate changes.
• Noninterest bearing vs. interest bearing
• Banks' interest-bearing costs correlate strongly with the Fed funds rate.
• Deposit beta (the degree to which deposits reprice to market rates) is determined by the level of core deposit and how "sticky" those deposits are.
• Non-core deposits, which can include brokered and uninsured deposits, are not stable.
• For example, a bank with a deposit beta of 50% and a 1% increase the Fed Funds rate will result in an increase in deposit rates by 0.5%.
• The majority of banks' securities portfolio are RMBS securities, which are typically fixed rate and price off of long-term interest rates (10-year Treasury).
• Rising long-term rates benefit reinvestment rates for securities that are rolling-off/maturing.
• Rising rates reduce the value of securities, in turn reducing tangible book values.
• This hits the AOCI (Accumulated Other Comprehensive Income) line item.
• Securities losses show up on the income statement when sold.
• A steeper yield curve (larger difference between short and long-term rates), makes carry trade more attractive.
• Higher interest rates may lead to improved earnings but can also increase the discount rate, resulting in a lower P/E multiple.
• Whether higher rates are good for banks if they are a pickup in real economic growth they benefit banks (higher NIMs, higher loan growth), and hurt if rates are driven by inflation rates.
• Credit risk is that a bank will not be repaid in full (principal and interest) by borrowers and/or counterparties.
• Net Charge-Offs (NCOs) occurs when a bank takes a charge-off on a loan is uncollectible.
• NCOs = Gross Charge-Offs - Recoveries (from previous charge-offs).
• NCOs / Average Loans measures the percentage of loans are charged off in a given time period
• Loss rates differ depending on whether loan is secured vs. unsecured.
• Nonperforming Loans (NPLs) occurs when a loan is 90-days past due
• The bank will stop accruing interest on the loan.
• Any interest that has been accrued is reversed and charged against the bank's loan loss reserve balance.
• NPLs / Loans is a measurement used to gauge future losses at a bank.
• Nonperforming Assets (NPAs) include both NPLs and other real estate owned (OREO), which are foreclosed properties that a bank has repossessed.
• NPAs / Total Assets is commonly used to help gauge future credit losses at banks.
• Troubled Debt Restructurings (TDRs) occurs when a loan is restructured due to a borrower's financial difficulties
• Banks will often lower interest rates, extend maturity, etc.
• Banks incur losses through increased provision expense to build loss reserves for these loans when classifying loans as TDRs.
• Loan Loss Provision Expense is the credit expense that flows through a bank's income statement, adding to loan loss reserve
• It is a positive sign when a bank's provision expense is greater than NCOs for a given period because the bank is building its loan loss reserve and points to increase charge-offs in future periods.
• The Allowance for Loan Losses (Loan Loss Reserves, LLR) is managements' estimate of probable or expected credit losses. LLRs are a contra asset to gross loans, is reduced when a loan is deemed uncollectible, and any subsequent recoveries on loans already charged off are credited back to the bank’s reserves.
• Banks consider historical loss experience, current delinquency rates, economic conditions, and credit scores of borrowers to gauge loan loss reserve balances.
• Under new accounting standards, the timing of credit loss provision expenses will be at origination or acquisition.
• Higher reserves allow a bank to absorb future credit losses, but may indicate inherent credit risk across the loan portfolio.
• Reserves / NCOs determine ability to cover future net charge-offs.
• Liquidity is the ability of a bank to fund cash demands at a reasonable cost.
• Cash demands include deposit withdrawals and new loan demand.
• Banks are exposed to liquidity risk because their liabilities are short-term and their assets are longer-term.
• Primary liquidity reserves:
• Vault cash
• Deposits held at the Federal Reserve
• Secondary liquidity reserves:
• Treasury bills
• Federal funds sold
• Reverse repurchase agreements
• Deposits placed with correspondent banks
• Negotiable CDs
• Government backed securities
• Liabilities to manage liquidity include:
• Federal funds purchased
• Repurchase agreements
• Jumbo CDs
• FHLB borrowings
• Fed discount window borrowings
• A bank can manage its liquidity two ways: having a sufficient amount of liquid assets on its balance sheet which it can convert to cash, or by having access to external funds through borrowing.
• Capital absorbs unexpected losses, reducing the risk of bank insolvencies.
• Capital is net of loan loss reserves and any losses exceeding what a bank has reserved for will reduce capital.
• Capital comes from funds used for growth through acquisitions, originations, and capital expenditures.
• Regulators prefer that banks run with higher capital, and shareholders prefer optimized levels of capital (returns).
• Higher capital levels decrease the risk of insolvency, but reduce a bank's competitiveness with other lenders.
• Capital requirements are a key prudential measure that banks must meet in order to promote public confidence in banking institutions, and capital serves as a layer of protection.
• Capital requirements trade-off safety and performance, and provide a buffer for losses but may also constrain bank's ability to lend.
• Federal bank regulators set current capital rules, these include:
• Office of the Comptroller of the Currency (OCC): Oversees nationally chartered banks
• Federal Reserve: Oversees state chartered banks outside of the Federal Reserve System
• Federal Deposit Insurance Corporation (FDIC): Oversees remaining state chartered banks
• The recommendations of the Basel Committee on Banking Supervision (BCBS) generally line up with the capital frameworks regulators establish.
• Capital requirements are expressed as ratios.
• Two categories of Requirements:
• Risk-weighted requirements: Measures how much capital depends on on the riskiness of the bank's assets.
• Leverage requirements: Measures how much capital is based on the total size of the bank's balance sheet (all assets are weighted equally)
• Common Equity Tier 1 Capital (CET1) includes the bank’s common stock, retained earnings and AOCI
• CET1 less Goodwill, Deferred tax assets and other intangibles

Capital Tiers

• Additional Tier 1 Capital (AT1) includes:
• Noncumulative perpetual preferred stock.
• Instruments from Small Business Lending Fund (SBLF) or Troubled Asset Relief Program (TARP).
• Risk-Weighted Assets (RWA) accounts for risk differences in the risk profiles of assets held by banks.
• 0%: Cash, Exposures guaranteed by the Fed, Treasury, US government.
• 20%:GSEs, US depositories, securitization.
• 50%: First-lien mortgages.
• 100%: Most non-bank corporate exposures, commercial real estate exposures, junior-lien residential mortgages.
  • *100% is default for items not specifically assigned to a risk-weight category.
• 150%: Loans 90 days past due.
• Risk weights for government and foreign banks depend on OECD membership/country risk classification. Risk-Weighted Capital Requirements are measured as: CET1 Capital = CET1/RWA, with adequate capitalization > 4.5%.
• Tier 1 Captial = Tier 1/RWA, with adequate capitalization > 6%.
• Total Capital = Total Capital/RWA, with adequate capitalization > 8%.
• Banks must hold CET1/RWA above 2.5% (CET1/RWA ≥ 7%) to avoid dividend restrictions under the Capital Conservation Buffer (CCB). The Capital Conservation Buffer (CCB) helps banks conserve capital

Leverage Ratios

• Measured as: Tier 1 Capital / Total Consolidated Assets > 4%
• Banks that are undercapitalized may face restrictions on asset growth and capital distributions until the FDIC approves a capital restoration plan.
• A four-tier system for US banks:
• Banks which are "too big to fail" cause financial stability.
• Category I, G-SIBs, have designations that are dictated by the Federal Reserve.

Banks with:

• Category II: >$700bn in assets.
• Category III: >$250bn in assets.
• Category IV: $100-250bn in assets.

Advanced Approaches

• Category I and II banks have more technical procedures to model risk.

• Supplementary Leverage Ratio (SLR) = Tier 1 Capital / Total Leverage Exposure and includes off-balance-sheet exposures.

• G-SIBs must also hold more capital to reflect the higher financial system risk. Capital surcharges depend on systemic importance, ranging between 1% and 4.5%.

• Stress Capital Buffer (SCB)

• Averages projected bank losses under a hypothetical economic/financial decline.

• It focuses on asset projections, not current asset values.

• SCB requires banks to exceed coverage of stress test losses and dividends or 2.5% of RWA (whichever is larger), as the 2.5% CCBs must have enough capital to cover stress test losses.

• SCB, CCG and Additional Requirements of CET1 must be followed.

The Demise of SVB - Net Interest

• Banks took in record volumes of new deposits during the pandemic.
• Loan demand was weak and securities were purchased. Between end of 2019 and Q1 2022, U.S. deposits rose $5.4tn, but most went into securities. Banks decide whether to hold securities to maturity.
• Held-to-Maturity (HTM), assets are marked down on the balance sheet at amortized cost, instead of to fair market value.
• Available-for-Sale (AFS) securities are marked to market.
• Selling a single bond in an HTM portfolio requires re-marking the whole portfolio.
• Banks reclassified AFS securities as HTM to avoid unrealized losses when rates rose in 2021.
• Silicon Valley Bank offered depository services to tech companies and venture-backed startups.
• SVB's customer base generated cash in 2020 and 2021 due to venture capital boom, and SVB's deposits tripled to $200bn by Q1 2022.
• Securities purchases included:
• $30bn in AFS securities
• $100bn in HTM securities
• Duration of SVB's HTM portfolio hit 6.2 years
• By Sept 2022, SVB took a 16% hit on its HTM portfolio, translating to $16bn in losses against $12bn in TCE.
• These losses weren't recorded, so management planned to sell existing securities and replace with higher yielding securities
• Deposits declined from $200bn in Q1 2022 to $170bn by the end of 2022 due to a deposit outflow across U.S. banks and people moving money to higher yielding assets with little rate on deposits.
• Declining deposits prompted SVB to sell its AFS securities at a loss.
• An issue was that out of $170bn deposits, $150bn was uninsured.
• SVB couldn't sell securities in its HTM portfolio without the entire portfolio's market being triggered.
• Regulators use the Liquidity Coverage Ratio (LCR) to stress test banks for interest rate risk.
• Required to hold high-quality liquid assets equivalent to 100% of projected cash outflows/30 days.
• SVB wasn't subjected to the Federal Reserve's LCR because they were deemed to small.