Like all businesses, banks profit by earning more money than what they pay in expenses.

The major portion of a bank's profit comes from the fees that it charges for its services and the interest that it earns on its assets. Its major expense is the interest paid on its liabilities. The major assets of a bank are its loans to individuals, businesses, and other organizations and the securities that it holds, while its major liabilities are its deposits and the money that it borrows, either from other banks or by selling commercial paper in the money market.

Profit Measures: Return on Assets and Return on Owners' Equity

The traditional measures of the profitability of any business are it return on assets (ROA) and return on equity (ROE). Assets are used by businesses to generate income. Loans and securities

are a bank's assets and are used to provide most of a bank's income. However, to make loans and to buy securities, a bank must have money, which comes primarily from the bank's owners in the form of bank capital, from depositors, and from money that it borrows from other banks or by selling debt securitiesa bank buys assets primarily with funds obtained from its liabilities as can be seen from the following classic accounting equation:
Assets = Liabilities + Bank Capital (Owners' Equity)

However, not all assets can be used to earn income, because banks must have cash to satisfy cash withdrawal requests of customers. This vault cash is held in its vaults, in other places on its premises such as tellers' drawers, and inside its automated teller machines (ATMs), and, thus, earns no interest. Banks also have to keep funds in their accounts at the Federal Reserve that, before October, 2008, paid no interest.

However, because of the credit crisis that was occurring at that time, the Federal Reserve started paying interest on banks' reserves, although it is much less than market rates. A bank must also keep a separate accountloan loss reservesto cover possible losses when borrowers are unable to pay back their loans. The money held in a loan loss reserve account cannot be counted as revenue, and, thus, does not contribute to profits. The ROA is determined by the amount of fees that it earns on its services and its net interest income:

Net Interest Income

= Interest Received on Assets - Interest Paid on Liabilities -

Interest Earned on Securities + Loans

Interest Paid on Deposits and Borrowings

Net interest income depends partly on the interest rate spread, which is the average interest rate earned on it

assets minus the average interest rate paid on its liabilities.

Graph spanning 1990 - 2008 showing the percentage of selected banks reporting increased interest rate spreads of C&I loans, credit card loans, and other consumer loans over the cost of funds.

Source: http://www.federalreserve.gov/pubs/bulletin/2008/articles/bankprofit/default. htm

Interest Rate Spread = Average Interest Rate Received on Assets Average Interest Rate Paid on Liabilities

Net interest margin shows how well the bank is earning income on its assets. High net interest income and margin indicates a well managed bank and also indicates future profitability.

Net Interest Margin =

Net Interest Income Average Total Assets

Graph spanning 1990 - 2007 showing the decline of net interest margin for all banks and a graph show the net interest margin decline for small and medium banks, and for the 100 largest banks.

Source: http://www.federalreserve.gov/pubs/bulletin/2008/articles/bankprofit/default. htm

The ROA for banks:

ROA

Fee Income + Net Interest Income Operating Costs Average Total Assets Net Income

= Average Total Assets

Because income is calculated over a time period, but assets, as a balance sheet factor, are determined at a particular time, average assets are used:
Averag e Total Assets = 2

Total Assets at End of Fiscal Year - Total Assets at Start of Fiscal Year

(Note: Herein we will refer to Average Total Assets as simply Bank Assets)

The return on equity is what the bank's owners are primarily interest in because that is the return that they earn on their investment, and depends not only on the return of assets, but also on the total value of the assets that earn income. However, to purchase more assets, a bank needs to pay for it either

with more liabilities or with bank capital. Therefore, if the owners want to earn a greater return, they would rather use liabilities rather than their own capital because this greatly increases their return. When a bank increases its liabilities to pay for assets, it is using leverage otherwise a bank's profit would be limited by the fees that it can charge and its interest rate spread. But the interest rate spread is limited by what a bank must pay on its liabilities and what it can charge on its assets. Since banks compete with each other for depositors and deposits compete with other investments, banks must a pay minimum market rate to attract depositors. Likewise, banks can only charge so much for loans since there is competition from other banks and businesses can get loans by selling debt securities, either commercial paper or bonds, in the financial markets. Hence, interest rate spreads are not wide and so a bank can only earn more net

interest income by increasing the number of loans that it makes compared with the amount of its bank capital which it does by using leverage:
Bank Assets Bank Capital

Leverage Ratio =

Now the return for the owners is easy to calculate:

ROE = Return on Assets x Leverage Ratio Net Income = Bank Assets Bank Assets Bank Capital

Net Income = Bank Capital

Graph spanning 1998 - 2007 showing the average ROE for all banks.

Data source: http://www.federalreserve.gov/pubs/bulletin/2008/articles/bankprofit/default. htm

The leverage that banks use is basically the same as a business using debt to increase its earnings. After all, deposits are just money that the bank owes to its depositors. Hence, the leverage ratio is the same as the debt ratio used to determine the leverage of other business types. The return on equity can be increased by increasing leverage, but banks can only increase leverage by so much, because with increased leverage comes

increased risk. For instance, consider the following hypothetical bank:

y y y

Bank Assets = $100 Bank Liabilities = $95 Bank Capital = $5

This is a leverage ratio of 20 to 1 ($100/$5). If the value of its assets drops just 5%, then the bank's capital will be wiped out. To protect the safety of the banking system, the Federal Reserve restricts the amount of leverage that banks that are depository institutions can use. Typically, the leverage ratio is about 10 to 12. In other words, a bank's assets have at least 10 times the value of its capital, but not much more. A major reason why most investment banks were not depository institutions was to escape such restrictions so that they could make outsized profits by using extremely high leverage. Rather than managing risk with reserves, these banks managed risk with their own

financial models. For example, Lehman Brothers was using a leverage ratio of greater than 30. With a leverage ratio this high, the value of its assets only had to decline 3% to wipe out Lehman Brothers' entire capital. When subprime borrowers started defaulting on their mortgages in large numbers in 2007 and 2008, the value of the mortgagedbacked securities that Lehman Brothers held as part of its portfolio fell dramatically in value. These large losses combined with its outsized leverage ratio forced Lehman Brothers to declare bankruptcy in September, 2008, after 160 years in the financial services business. This is why banks must manage risk very carefully.

Bank profitability showing both return on assets and return on equity from 1985 - 2007.

According to a Credit Rating and Information Services of India (Crisil) study, Lower operating expenses including rationalisation of employee costs have improved the profitability of banks, contrary to the popular perception that only trading profits helped the banking sector shore up their bottomlines. The reduction in operating expenses was achieved through largescale voluntary retirement schemes implemented by public sector banks. Since this reduction in operating expenses seems sustainable, it promises a brighter future for the banking sector. Although the non-interest income of banks did increase by 0.3% during this period, it was more than offset by a 0.21% increase in provisions and an identical decline in spreads. Compared to the relatively volatile treasury income, the reduction in operating expenses imparts a greater level of comfort in terms of the banking sector's ability to sustain its profitability in the future. The banking sectors overall profitability as measured by the return on average assets (RoAA) has improved to 0.84 per cent in 2001-02 from 0.53 per cent in 2000-01. An analysis of the incremental change in the various profitability components shows that: * In 2001-02, the sectors non-interest income rose by 32 basis points (bps) over the previous year, primarily due to an increase in treasury profits. On the other hand, the net interest income or interest spread declined by 21 bps in the same period. This was in line with the declining interest rate regime and increasing competition in the sector. At the same time, provision and contingency charges rose by 21 bps. Together, the two more than offset the incremental contribution from the non-interest income. * Operating expenses, however, declined significantly by 41 bps in 2001-02 over 2000-01 and this enabled the banking sector to report an overall increase in profitability by 31 bps. The reduction in operating expenses can

be attributed to the large-scale voluntary retirement schemes (VRS) being implemented across all public sector banks as well as other cost-cutting measures. A closer analysis of the different banking groups (public sector banks, old private sector banks, new private sector banks and foreign banks) also shows that the reduction in operating expenses was only experienced by the public sector and foreign banks. For private sector banks, the profitability improvement was mainly because of the increase in treasury income and not due to any material reduction in operating expenses. But since public sector and foreign banks account for over 80 per cent of the total assets of all scheduled commercial banks, a reduction in their core operating expenses contributes significantly in improving the profitability of the entire Indian banking sector. Crisil believes that the banking sector is now reaping the benefits of rationalising its employee costs and undertaking other cost-reduction initiatives, which is a welcome sign in terms of the banks financial performance. Crisil, however, pointed out that banks ability to repeat and sustain such efforts would be critical in maintaining their profitability, given the increasing pressure on interest spreads and rising provisioning levels.