How Financial Institutions Make Money?

there are three main sources of revenue and expense for financial institutions which are:

  1. Net Interest Income: Banks get money from individuals, they pay the interest to them. they buy some instruments with the money and receive interest from the instruments.

Net Interest Income= Interest Income- Interest Expense

Interest Income= Interest received from clients, from securities invested in,…

Interest Expense= Interest Paid to clients, paid to other banks for loan

2. Fee Income: it is coming from the charged fees to the customers. in investment banks they do not take money and loan money, so it comes from fee income. (transaction fee, Advisory fee, asset management fee (Percentage of total asset), trading gain (Usually proprietary trading), capital gain (Profit from buying and selling the instruments))

3. Operational Expenses (Non Interest Expense): all the costs for running the business other than the interest expense, taxes and provisions.

Net Income= 1+2–3

in addition to the net interest income, the Net interest Spread and Net interest Margin are also important in our analysis.

Net Interest Spread= Yield in asset — cost of Funds

Net Interest Margin= Net interest Income/ Earning Asset

Interest rate income is usually constant while the interest rate expense can be changed by the central bank's decision. this leads to a risk which is called Interest Rate Risk.

the main procedure for interest rate risk management is ALM or Asset, Liability Management.

the process of interest rate risk management

one of the ways in the ALM and risk management process is Considering Provision for Credit/loan loss ( or Impairment charge). this is subtracted from the net interest income to calculate the institute's net interest income after provision for loss.

Fee Income:

this is the main source of revenue for nonbank financial institutions and investment banks. fee income is more stable than the net interest income. fee-based businesses need less initial capital.

Non Interest Expenses:

one of the main parameters that show the effectiveness of business of a bank is called be efficiency ratio. (occupancy cost, Compensation cost, equipment expenses, other expenses (legal, consulting fees to others…).

……………………..

the two important assets that a financial company can have are the Loans given to the clients (Loans outstandings or net loan), and the deposits on the other banks.

Net loan= Gross Loan- Allowance for credit losses (Loan Loss Reserve)

Main KPIs of the Financial Companies:

Return on Equity= Net income/ Average Equity

Return on Asset= Net income/ Average Asset

Efficiency ratio= Operating Expense/ Revenue it should be below 60%

Spread= difference between the yield on assets and cost of funds

Net interest Margin= Interest Income/ Earning Assets

Regulations of the Banking industry:

the regulators ask the banks to have a minimum capital ratio. the purpose is to safeguard the minimum ability of bank to protect itself against defaults.

according to Basel III there are different capital ratios depending on the level of risk in the assets. for example, the government bonds are 0 risks, mortgage loans are 50% risk and the loans are 100% risk ranked.

Banks must comply according to regulations to four different categories of capital ratios.

Where to find the information of the banks:

US: FDIC Bank Info

Bafin Database: Germany

OFSI: Canada

--

--

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store
Iman Najafi

Iman Najafi

An Enthusiast Equity Analyst and Independent Financial Researcher with a passion for Fundamental Analysis. I use Medium for the daily records.