Fundamentals of Banking Institutions

Topic 2: Overview of Bank Profitability

Agenda

 Introductory comments

 Review of Profitability Analysis for non-Banks

 Overview of Bank’s Profitability Analysis

 Analyzing of Bank’s ROE and ROA

 Summary of takeaways

Fundamentals of Banking Institutions by Prof. Liang 2

 REVIEW OF PROFITABILITY FOR NON-BANKS

Fundamentals of Banking Institutions by Prof. Liang 3

Illustration of Non-Bank's Balance Sheet and Income

Statement
use of fund
Operating Assets PPE Fin Assets e.g. cash/marketable securities
Op Liab Equity Fin Liab source of fund
long-term debt

Fin
(Op) Revenue Rev

Operating Expenses Net Income Tax Int Exp

Fundamentals of Banking Institutions by Prof. Liang 4

 Profitability Measurement: Non-Banks

Financial Statement Line-Items (FSLI) Common Metrics

 Revenue (or Sales) net income/revenue Profit Margin
 Earnings Before Int. and Tax (EBIT)
 Interest Expense revenue/total asset Asset Turnover
 Tax Expense
 Net Income Return on Assets

 Total Assets net income/equity Return on Equity

 Total Liab
 Shareholders’ Equity Cost of Debt
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Profitability Decomposition (What’s the story?)

 The Easy Story:

𝑁𝐼
𝑅𝑂𝐸 = = profit margin*asset turnover*equity multiplier
𝐸𝑞𝑢𝑖𝑡𝑦

 A Better Story:

𝑁𝐼
𝑅𝑂𝐸 = = EBIT margin*tax burden*interest burden*asset turnover*equity multiplier
𝐸𝑞𝑢𝑖𝑡𝑦

https://www.wallstreetprep.com/knowledge/dupont-analysis-template/
Fundamentals of Banking Institutions by Prof. Liang 6
 OVERVIEW OF BANK’S PROFITABILITY

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An illustration of Bank's Balance Sheet and Income

Statement

Interest-bearing Assets Non-Interest-bearing Assets

Interest-bearing Liab Non-Interest-bearing Liab SE

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 Income Statement Measurements: Comparison

Non-Banks Banks
Net Revenue (or Net Sales) Interest Income
[minus] COGS (or COS) [minus] Interest Expense
= Gross Profit = Net Interest Income
[plus] Non-interest Income
[minus] Operating Expenses
= Total Revenue
= Earnings Before Int. and Tax (EBIT)
[minus] Provision for Credit Losses (PCL)
[minus] Interest Expense
[minus] Operating Expenses
[minus] Tax Expense
= Earnings Before Tax (EBT)
= Net Income [minus] Tax Expense
= Net Income
Fundamentals of Banking Institutions by Prof. Liang 9

Balance Sheet and Income Statement

Citigroup Fiscal Year
Income Statement Summary 2020 2019 2018 2017
Interest Income 58,089 76,510 70,828 61,579
Interest Expense 14,541 29,163 24,266 16,518
Net Interest Income (NII) 43,548 47,347 46,562 45,061
Non-interest Income 30,750 26,939 26,292 27,383
Totoal Revenue (net of interest expenses) 74,298 74,286 72,854 72,444
Provision for credit losses (PCL) and for benefits and claims 17,495 8,383 7,568 7,451
Total Operating Expenses 42,781 42,002 41,841 42,232
Income Before Taxes 14,022 23,901 23,445 22,761
Income Taxes 2,592 4,430 5,357 29,388
Loss from discontinued operations, net of taxes (20) (4) (8) (111)
Net Income 11,410 19,467 18,080 (6,738)
Citigroup Fiscal Year
Balance Sheet Sumary (avg of BOY and EOY) 2020 2019 2018 2017
Total Assets 2,105,740 1,934,271 1,879,924 1,817,271
Loans and leases, net of allowance 675,883 699,483 684,196 667,034
Total Liabilities 1,908,505 1,738,761 1,680,551 1,603,364
Deposits 1,175,631 1,041,880 986,496 944,614
Preferred Stocks 31 31 31 31
Common Equity 197,204 195,479 199,342 213,877
Total SE 197,235 195,510 199,373 213,908
Fundamentals of Banking Institutions by Prof. Liang 10
 Profitability Measurement: Banks

Financial Statement Line-Items (FSLI) Common Metrics (for non-banks)

 Net Interest Income 11B/74B=15.3% Profit Margin
 Non-interest Income
 Provision for Credit Losses (PCL) 74B/2.1T=0.035
Asset Turnover
 Earnings Before Tax (EBT)
 Tax Expense Return on Assets
 Net Income
 Total Assets (interest-bearing or not) 11B/197B=0.055 Return on Equity
 Total Liab (interest-bearing or not)
 Shareholders’ Equity Cost of Debt
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Profitability Decomposition for BANKS

 The Easy Story:

𝑁𝐼
𝑅𝑂𝐸 = =
𝐸𝑞𝑢𝑖𝑡𝑦

 A Better Story:

𝑁𝐼
𝑅𝑂𝐸 = =
𝐸𝑞𝑢𝑖𝑡𝑦

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 ANALYZING BANK’S ROE AND ROA

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ROE Decomposition Analysis

 Starting Point ROE (Net Income/SE)

NI NII  OtherInc  PLL  OtherExp
ROE  
SE SE

 Use a third decomposition

NI NI  IntExp TotalLiab  NI  IntExp IntExp 
ROE      
SE TotalAssets SE  TotalAssets TotalLiab 

 In Words:
Return on Equity = Return on Assets + Leverage (Return on Assets – Int. Costs%)

 This decomposition clearly shows the role of leverage

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 ROE Decomposition Analysis – Step-1

 Starting Point ROE (Net Income/SE)

NI NII  OtherInc  PLL  OtherExp
ROE  
SE SE

 Step-1: add and subtract interest expense to the numerator

. ( %) . ( %)
ROE = =

. ( %) . ( %)
= −

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ROE Decomposition Analysis – Step-2 and -3

 Step-2: Multiple the first half by total assets/total assets. Multiply second half
by total liabilities/total liabilities.
. ( %) . ( %)
ROE = ∗ - ∗

𝑁𝐼 + 𝑖𝑛𝑡. exp(1 − 𝑡𝑎𝑥%) 𝑇𝐴 𝑖𝑛𝑡. exp(1 − 𝑡𝑎𝑥%) 𝑇𝐿

= ∗ − ∗
𝑇𝐴 𝑆𝐸 𝑇𝐿 𝑆𝐸

 Step-3: Break total assets up into total liabilities plus share holder’s equity

𝑅𝑂𝐸 = 𝑅𝑂𝐴 ∗ − ∗ 𝑖𝑛𝑡. 𝑐𝑜𝑠𝑡%

𝑅𝑂𝐸 = 𝑅𝑂𝐴 ∗ + − ∗ 𝑖𝑛𝑡. 𝑐𝑜𝑠𝑡%

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 ROE Decomposition Analysis – Step-4 and -5

 Step-4: SE/SE goes to 1 and Distribute ROA.

𝑅𝑂𝐸 = 𝑅𝑂𝐴 + 𝑅𝑂𝐴 − ∗ 𝑖𝑛𝑡. 𝑐𝑜𝑠𝑡%

 Step-5: Take out the common factor

𝑅𝑂𝐸 = 𝑅𝑂𝐴 + (𝑅𝑂𝐴 − 𝑖𝑛𝑡. 𝑐𝑜𝑠𝑡%)

5.8%=1%+9.7(1%-0.5%)

Return on Equity = Return on Assets + Leverage (Return on Assets – Int. Costs%)

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Balance Sheet and Income Statement

Citigroup Fiscal Year
 For CITI FY2020 Income Statement Summary 2020 2019 2018 2017
Interest Income 58,089 76,510 70,828 61,579
Interest Expense 14,541 29,163 24,266 16,518
Net Interest Income (NII) 43,548 47,347 46,562 45,061
ROE = 11B/197B=5.8% Non-interest Income 30,750 26,939 26,292 27,383
Totoal Revenue (net of interest expenses) 74,298 74,286 72,854 72,444
Provision for credit losses (PCL) and for benefits and claims 17,495 8,383 7,568 7,451
ROA Total Operating Expenses 42,781 42,002 41,841 42,232
Income Before Taxes 14,022 23,901 23,445 22,761
[11B+14B(1-7%)]/2.1T=1%
Income Taxes 2,592 4,430 5,357 29,388
+ Loss from discontinued operations, net of taxes (20) (4) (8) (111)
1.9T/197B=9.7 Net Income 11,410 19,467 18,080 (6,738)
LEV Citigroup Fiscal Year
Balance Sheet Sumary (avg of BOY and EOY) 2020 2019 2018 2017
Total Assets 2,105,740 1,934,271 1,879,924 1,817,271
x Loans and leases, net of allowance 675,883 699,483 684,196 667,034
Total Liabilities 1,908,505 1,738,761 1,680,551 1,603,364
Spread Deposits 1,175,631 1,041,880 986,496 944,614
Preferred Stocks 31 31 31 31
Common Equity
14B(1-7%)/1.9T=0.5% 197,204 195,479 199,342 213,877
Total SE 197,235 195,510 199,373 213,908
Fundamentals of Banking Institutions by Prof. Liang 18
 Standard ROE decomposition

Citigroup Fiscal Year

Profitability Analysis 2020 2019 2018 2017
Return on Equity (ROE) 5.78% 9.96% 9.07% -3.15%
Marginal Tax rate 21% 21% 21% 35%
Return on Assets (ROA) 1.09% 2.20% 1.98% 0.22%
Leverage (Liab/SE) 9.68 8.89 8.43 7.50
After-tax Interest Costs (=IntExp(1-tax%)/Liab) 0.60% 1.33% 1.14% 0.67%
Spread (ROA - After-tax Interest Cost) 0.49% 0.87% 0.84% -0.45%
Leverage Contribution to ROE (Lev x Spread) 4.70% 7.76% 7.09% -3.37%
ROE = ROA + Leverage Contribution to ROE 5.78% 9.96% 9.07% -3.15%

increasing leverage slightly, but smaller spread, ROE meager

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ROA: Individual Components

Interest Income Non-interest Income

 As % of total assets  As % of total assets
IntIncome OtherIncom e
rA  fee % 
TotalAsset s TotalAsset s
Combined Earnings on Assets (EOA)
IntIncome  OtherInc
EOA   rA  fees%
TotalAssets

 As % of interest-earning assets
IntIncome
rA* 
Intbearing Assets
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 ROA: Individual Components

Interest Expense Provision for Credit Losses

 As % of total Liabilities  As % of total assets

IntExp 𝑃𝐶𝐿
rL  𝑃𝑅𝑂 =
𝑇𝑜𝑡𝑎𝑙𝐴𝑠𝑠𝑒𝑡𝑠
TotalLiab

 As % of interest-earning Liab

IntExp
rL* 
Intbearing Liab

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ROA: Individual Components

Operating Expense Income Taxes

 As % of Total Assets  As % of EBIT

NICR= = × Tax%on𝐸𝐵𝐼𝑇 =

ROA Composition

𝑁𝐼 + 𝑖𝑛𝑡. exp(1 − 𝑡𝑎𝑥%)

𝑅𝑂𝐴 =
𝑇𝐴
= 𝑟 + 𝑓𝑒𝑒% − 𝑁𝐼𝐶𝑅 − 𝑃𝑅𝑂 1 − 𝑡𝑎𝑥%𝑜𝑛𝐸𝐵𝐼𝑇

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 ROA: Individual Components
Citigroup Fiscal Year
Profitability Analysis 2020 2019 2018 2017
Return on Assets (ROA) 1.09% 2.20% 1.98% 0.22%
ROE = ROA + Leverage Contribution to ROE 5.78% 9.96% 9.07% -3.15%
Decompositions of ROA
Interest Income on Assets (r_A=IntIncome/Assets) 2.76% 3.96% 3.77% 3.39%
Earnings on Assets (EOA=IntIncom+OtherInc)/Assets) 4.22% 5.35% 5.17% 4.90%
Provisions on Assets (PRO=PCL/Assets) 0.83% 0.43% 0.40% 0.41%
Efficiency Ratio (total operating expense/total revenue, net) 57.6% 56.5% 57.4% 58.3%
(Total) Assets Turnover (total rev, net/total assets) 0.04x 0.04x 0.04x 0.04x
Non-Interest-Cost-Ratio (NICR=OtherExp/Assets) 2.03% 2.17% 2.23% 2.32%
Tax% On EBIT (= (Income Tax Provisions + Interest Tax shield) /
Earnings Before Interests & Taxes) 19.77% 19.89% 21.91% 89.54%
ROA =(EOA-PRO-NICR) (1-tax% on EBIT) 1.09% 2.20% 1.98% 0.23%

pre-tax Interest Costs (r_L=IntExp/Liab) 0.76% 1.68% 1.44% 1.03%

Pre-tax interest rate spread based on (r_A - r_L) 2.00% 2.28% 2.32% 2.36%
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New Normal: what a difference a decade makes?

Bank of America Fiscal Year
Profitability Analysis 2008 2007 2006
Return on Equity (ROE) 2.48% 11.86% 18.88%
Marginal Tax rate 35% 35% 35%
Return on Assets (ROA) 1.71% 3.22% 3.70%
Leverage (Liab/SE) 9.91 10.26 10.62
After-tax Interest Costs (=IntExp(1-tax%)/Liab) 1.63% 2.38% 2.27%
Spread (ROA - After-tax Interest Cost) 0.08% 0.84% 1.43%
Leverage Contribution to ROE (Lev x Spread) 0.76% 8.64% 15.18%
ROE = ROA + Leverage Contribution to ROE 2.48% 11.86% 18.88%
Decompositions of ROA
Interest Income on Assets (r_A=IntIncome/Assets) 4.85% 5.61% 5.80%
Earnings on Assets (EOA=IntIncom+OtherInc)/Assets) 6.40% 7.65% 8.58%
Provisions on Assets (PRO=PLL/Assets) 1.52% 0.53% 0.36%
Efficiency Ratio (total operating expense/total revenue, net) 57.1% 54.7% 48.4%
(Total) Assets Turnover (total rev, net/total assets) 0.04x 0.04x 0.05x
Non-Interest-Cost-Ratio (NICR=OtherExp/Assets) 2.35% 2.36% 2.60%
Tax% On EBIT (= (Income Tax Provisions + Interest Tax shield) /
Earnings Before Interests & Taxes) 32.48% 32.36% 33.99%
ROA =(EOA-PRO-NICR) (1-tax% on EBIT) 1.71% 3.22% 3.70%
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 A long way from 2008 crisis

CITI 2020 BOA 2006

 ROE
 ROA
 Leverage
 Spread

 r_A
 Fees%
 PRO
 Tax rate
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Summary of Takeaways

 Standard Profitability Decomposition for non-banks

 The easy story
 The better story

 Bank’s Profitability Decomposition

 A third story: importance of leverage in bank profitability
 How to decompose bank ROA
 Standard decomposition (profit margin x asset turnover) makes less sense

 New Normal: low rates, low fees, and lower leverage

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