Understanding banking earnings

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It all comes down to driving the most important metric of all in banking: return on equity. There are far too many corporate management teams that don’t pay enough attention to return on capital. In banks, where you theoretically have the most financially literate of all management teams, there is a deep understanding of the need to achieve adequate returns on capital deployed into the market.

But chasing interest revenue without a lucrative NIM is like growing a retailer that has poor gross profit. To maximise NIM, a bank either needs to charge more, which is difficult due to the level of competition in the market, or reduce the cost of funding. The cost of funding is a key differentiator among banks, as it comes down to the quality of the deposit book.

There’s one more ingredient in the recipe for core banking operations that varies considerably when you compare different banks: the credit loss ratio. This speaks to the quality of the book and is balanced against the pricing on the loans. For example, a book with a higher mix of personal loans – unsecured debt – will earn a higher net interest margin on a pre-provision basis, but this can easily be watered down or even destroyed by a credit loss ratio that might be out of control.

Basic examples of this include the bank charges on your account. More advanced examples include investment banking deal origination fees, or advisory fees, or trading profits. What about the insurance business within a bank, or the fees generated in the wealth management operations?This is where the best banks really shine, as they find ways to grow non-interest revenue to become a major component of total income.

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