How Banks Make Money
A bank borrows money cheaply and lends it more expensively. Its balance sheet is the business itself, which is why banks are read differently from other companies.
Why this matters for beginners
Ordinary measures mislead for banks. Without understanding interest margin, loan losses and capital, a cheap-looking bank can be a badly damaged one.
Main explanation
Banks earn net interest income: the difference between interest received on loans and interest paid on deposits and borrowing. Fees from services add a second income stream.
Net interest margin expresses that spread relative to assets. It widens and narrows with interest rates and with competition for deposits.
Loan losses are the main danger. When borrowers stop paying, provisions rise and profit falls quickly, which is why credit quality matters more than revenue growth.
Capital ratios show how much loss a bank can absorb before it is in trouble. Regulators set minimums, and a well-capitalised bank can keep lending through a downturn.
Example using a real company
A bank pays two percent on deposits and earns five percent on loans. The three percent spread funds its staff, systems and losses, and what remains is profit.
- →Rising rates widen the spread and lift profits, at least for a while.
- →A recession lifts loan losses and provisions, cutting profit sharply.
Common beginner mistakes
- ✕Judging a bank on a low earnings multiple without checking credit quality.
- ✕Ignoring capital ratios entirely.
- ✕Assuming deposits are a free and permanent source of funding.
Key terms
- Net interest margin
- The spread between interest earned and interest paid, relative to assets.
- Loan loss provision
- Money set aside for loans expected to go bad.
- Capital ratio
- A measure of how much loss a bank can absorb.
Key takeaways
- 01Banks earn a spread, so rates and competition drive revenue.
- 02Credit losses are the main risk to profits.
- 03Capital decides resilience in a downturn.
Check yourself
- 01Net interest margin measures the spread between lending and funding costs.
- 02Loan losses have little effect on bank profits.
- 03Capital ratios indicate how much loss a bank can absorb.
Try the concept on a real company
Study a large bank in the Analyzer and note how its profits changed during periods of economic stress.
Educational examples only. Not buy or sell recommendations.