We are all familiar with banks. Bank branches are still common on street corners and many of us use bank accounts to manage our personal finances. Banks are foundational to the financial system.

The Different Types of Banking

There are many different types of banking. So when we refer to “banking,” we are referring to a wide range of financial services. These different types of financial services can be categorized as follows:

• Retail banking. Retail banking is the part of banking that intersects with the retail customer. You can think of this as personal banking. Bank branches are the brick-and-mortar version of retail banking. Bank tellers and personal bankers help clients with their banking needs like cash, checking accounts, savings, and mortgages. Mobile banking is the more recent version of retail banking. It connects personal clients with their accounts and related services through the use of smart phones. The “UI/UX” (user interface / user experience) of a banking app can be critical to acquiring and retaining customers. Many banks are closing branches, but some are trying to reinvent the bank branch as a “third space,” like the Capital One Cafe. Younger generations do not use branches in the same way as older generations. Another term for retail banking is “consumer banking.” Consumer credit products like credit cards, auto loans, and mortgages are a part of retail banking. Wealth management is also an important aspect of retail banking for some banks. Some larger banks categorize small business lending as a form of retail banking.
• Commercial banking. Commercial banking is the traditional revenue generator for banks. This is lending to commercial clients using lines of credit (a revolver like a credit card for working capital) or term loans for project finance. Banks typically earn higher amounts of interest revenue on commercial loans, because they must be structured to serve the unique circumstances of the business. Consumer lending is more of a “commodity” (standardized) product, whereas commercial lending is more of a “tailored” (specialized) product. Tailored products are more expensive (just like in clothing). The core of commercial banking is middle-market lending, which is lending to mid-sized corporate clients. Middle-market firms are larger than small businesses but smaller than large, national corporations. There are typically companies with a regional footprint. Chicago banks specialize in lending to middle-market firms in the Midwest market. Commercial banking also includes commercial real estate lending, such as office buildings and multi-family housing.
• Corporate and investment banking. Corporate and investment banking focuses on the largest corporations. The financial services provided in this space are more often focused on valuation and external sources of funding. Rather than providing the funding in the form of a loan, corporate and investment banking is about helping large clients raise funding. “Corporate” in corporate banking typically serves a tier of firms between commercial banking and investment banking. A classic service of investment banking is merger and acquisition (M&A) advisory. The bank works for a firm that wants to be sell itself or some business line or the bank works for a firm that wants to buy some other firm or business line. Investment banking also involves a connection to capital markets. Investment banks help their clients issue securities and then provides liquidity in the trading of those securities.
• Universal banking. Universal banking combines all aspects of the above banking types. For instance, J.P. Morgan provides retail banking, commercial banking, corporate banking, and investment banking. The goal of combining these two forms of banking is to provide synergies between them. In contrast, Goldman Sachs has traditionally been a more narrowly focused investment bank (although this is changing with the introduction of “Marcus.”)

The Different Types of Banks

There are many different types of banks. They range in scale (small to big) and scope (narrow focus to wide focus). Here are some key categories in the types of banks:

• Global banks. The largest banks operate at a global scale. For instance, some European banks like Barclays, UBS, and Deutsche Bank operate in the U.S. through their New York operations. The global, universal U.S. banks are J.P. Morgan (JPM), Bank of America (BAC), and Citi (C).
• Foreign banks. Some U.S. banks are owned by foreign parents. BMO and CIBC are examples of Canadian owned banks.
• National banks. National banks are banks that have a presence across the country, but not much outside the country. Wells Fargo is an example of a national bank.
• Regional banks. Regional banks have a presence in a particular region of the country. Fifth Third is an example of a regional bank in the U.S.
• Community banks. Community banks have a presence in a particular city or community. Wintrust and Byline are examples of community banks (although they are both quite large for a community bank). Burling Bank on Jackson Blvd. is an example of a one-office community bank.

The banking sector has been consolidating for many years. This means that the larger banks have been acquiring the smaller banks. This has resulted in a smaller number of larger banks.

The Banking Business Model

The traditional business model of banking is taking deposits and making loans. This is the classic role of financial intermediary. It is also the defining role of banks in the indirect channel of finance.

Why do banks function as financial intermediaries? The most common explanation relates to information. Smaller borrowers are less transparent, which makes it difficult for them to access capital markets. Banks serve these types of borrowers by collecting information. Banks screen borrowers (collect information in the underwriting process) and monitor borrowers (collect information over the course of the loan). In this way, they are reducing the information asymmetry between the borrower and the lender.

Commercial banks make money on the difference between interest paid on deposits and interest earned on loans. This difference is justified by their role in collecting information.

In contrast, investment banking is primarily a fee based business. Investment banks make money by helping clients issue securities and serving as broker-dealers in capital markets. An example of their role in securities issuance would be an investment bank serving as the lead arranger in a company’s initial public offering (IPO). The broker-dealer role is the sales and trading business of investment banking. An investment bank can have a “trading desk” in any financial market. Examples of trading desks include equity, fixed income, currencies, and commodities. Goldman Sachs (GS) is the quintessential U.S. investment bank. Goldman managed to increase their share price during the COVID pandemic based on sales and trading.

Loan Growth and the Economy

Commercial banks make money by making loans. For banks to lend money, there needs to be demand for loans from borrowers of sufficient credit quality. Loan demand and credit quality tend to be high in economic expansions. In contrast, loan demand and credit quality tend to be low in economic contractions. This implies that loan volumes increase in the expansionary part of the economic cycle and decrease in the contractionary part of the economic cycle. Here is a chart of the growth rate of loan volumes in the U.S. since 2006:

This data collected by the Federal Reserve shows the annualized month-over-month percent change in loans and leases on bank balance sheets. As you can see, annual growth rates averaged around 10% in 2006 and 2007 prior to the global financial crisis. Loan volumes began contracting (negative growth rates) in 2008 and continued to contract through the spring of 2011. This was a lengthy recovery for the crisis. As the U.S. economy slowly recovered, loan growth gradually recovered as well. When loans resumed positive growth from 2011 to 2019, annual growth rates averaged around 5%.

The year 2020 marked an unprecedented period in U.S. loan growth due to COVID-19. Loan growth rates spiked in March and April of 2020 with +40% loan growth rates. This was due to firms drawing down credit lines (borrowing on a revolving line of credit) and the U.S. government implementing the Paycheck Protection Program (PPP). However, since June 2020, loan growth has continued to remain negative, averaging -6% annual rates of contraction. This continual contraction in bank loans since the summer of 2020 raises questions about the strength of the current economic recovery. It also has put downward pressure on bank earnings.

Commercial Bank Profitability and Interest Rates

Commercial banks’ business model closely relates to their corporate structure and profitability. As noted above, banks receive deposits as a source of funding and they make loans as a way to invest the money. Therefore, deposits are the key liability of commercial banks and loans are the key asset of commercial banks. Banks borrow money from depositors and lend money to other borrowers. There are other sources of funding and other types of investing, but deposits and loans are the quintessential liability and asset of a commercial bank, respectively.

Banks pay interest on deposits and earn interest on loans. The interest paid on deposits is an interest expense and the interest earned on loans is interest revenue. Interest revenue minus interest expense is net interest income (NII). Net interest income is the difference between interest earned on interest-bearing assets and interest paid on interest-bearing liabilities.

Because NII is in dollar amounts, it can be higher or lower depending on the size (scale) of the bank and the amount of lending. If interest rates remain constant but lending changes, then NII will reflect changes in lending volume. Loan growth in an economic expansion causes NII to rise and loan contraction in an economic slowdown causes NII to fall.

Net interest margin (NIM) is a key metric for the profitability of a commercial bank. Net interest margin is net interest income relative to interest-bearing assets. Therefore, it is expressed as a percentage. It is a measure of the profitability of assets that controls for the amount of lending (the base). As a formula, net interest margin is

Net interest margin is closely related to the level of interest rates.

Loans tend to be longer term than deposits. Therefore, it sometimes said that banks “borrow short and lend long.” This makes bank profitability closely tied to long-term interest rates.

Here is a chart that shows the close correlation between the average net interest margin of U.S. banks and the 10-year U.S. Treasury yield since 1990:

The average commercial bank net interest margin was about 4.5% in the early 1990s. Bank net interest margins in 2020 are now below 3%. As can be seen, this is largely due to falling long-term interest rates. Falling long-term rates have caused banks’ net interest margins to decline. A low-interest rate environment puts significant downward pressure on bank profitability. As a consequence, monetary stimulus has mixed implications for bank profitability. A boost to the economy is good for banks. However, lower rates squeeze bank profitability. Banks around the world have struggled with low profit margins due to the global phenomenon of low interest rates.

The relationship between bank profitability and interest rates means that banks are cyclical firms. When long-term rates rise (in a growing economy), bank profitability and share prices tend to increase. In contrast, when long-term rates fall (in a slowing economy), bank profitability and share prices tend to decline. Long-term rates (like the 10-year yield) have begun to rise again in 2021 with expectations of an economic recovery, which has increased the outlook for U.S. commercial banks’ net interest margins in 2021.

Taking Credit Risk in Banking

As in investment management, banks generate money by taking risks. Higher risk, higher return. The challenge is to take on a sustainable amount of risk. In the traditional business model of banking, the key risk is the risk of lending. For bank loans, the risk is loan default. This occurs when the borrower does not repay the loan.

Banks take on credit risk by making loans. Banks can take on less risk by lending to safer borrowers at lower interest rates or banks can take on more risk by lending to riskier borrowers at higher interest rates. Some banks diversify their loan portfolios by lending to a mix or safe and risky borrowers, while other banks specialize more in safer or riskier borrowers. This is similar to bond investors allocating funds across investment grade and non-investment grade bonds.

Loans are the key asset of commercial banks. Therefore, lending to riskier borrowers will generate a higher return on assets (ROA). Banks that lend to riskier borrowers can generate higher returns. However, the risk of default is always looming. When a bank lends to risky borrowers at a high rate and the borrowers repay the loan, the bank makes higher returns than more risk-averse banks. However, if the risky borrowers stop repaying, the bank will lose money and have significant negative returns. This is what happened in the lead up the subprime mortgage crisis in 2007-2008. Banks originated riskier mortgages at higher rates under the belief that the U.S. housing market expansion would keep defaults at a minimum. When the housing market collapsed and borrowers could no longer repay their subprime mortgages, the banks that made the riskiest mortgages failed.

Taking Leverage Risk in Banking

Every balance sheet has two sides. The left-hand side is Assets and the right-hand side is Liabilities + Equity. It is called a balance sheet because

Assets = Liabilities + Equity.

The goal of corporate executives is to maximize shareholder value. This is the traditional mantra of post WWII capitalism. The shareholders are the owners of the firm, which is the equity position on the right-hand side of the balance sheet. Maximizing shareholder value means management makes decisions that maximize the return on equity (ROE). The owners of a firm (the equity shareholders) benefit from a high ROE.

A basic formula for return on equity is the following:

This shows the managers can increase ROE in two basic ways.

One way to increase ROE is to increase ROA. A firm can increase ROA by investing in assets that generate higher returns. All else equal, higher ROA will result in higher ROE. In the banking sector, this means that a bank can increase ROE by making loans at higher interest rates. This is one element of how bank risk-taking generates returns for the shareholders.

The second way to increase ROE is to increase leverage. The second term in the ROE equation (Assets/Equity) is a measure of leverage. A firm with a higher amount of assets relative to equity is operating with a large amount of debt. This is a highly leveraged (levered) firm. This term is also referred to as the equity multiplier. If ROA is 1% and a firm is operating with an equal amount of debt and equity, then the equity multiplier is 2 and the ROE is 2%. In this way, leverage magnifies the return on assets to generate higher returns on equity. This is the same concept of using leverage (borrowed money) to magnify returns in investing. The downside is that leverage magnifies losses when returns are negative.

Bank equity is often referred to as capital. Capital is the equity ownership in the bank. Banks with a large amount of debt relative to equity have high leverage. The inverse of leverage in banking is the capital ratio. The capital ratio is the ratio of capital to assets. A bank with a low capital ratio has high leverage and a bank with a high capital ratio has low leverage.

Rewriting the ROE equation in the language of banking, we have:

This shows that a bank with a low capital ratio will have a high return on equity. For example, a bank with 85% debt and 15% capital will have a capital ratio of 0.15. If the bank’s ROA is 1%, then its ROE is 6.67%.

Banks that operate with higher leverage (a lower capital ratio) can generate higher returns for their shareholders. However, greater leverage also means greater risk of bankruptcy.

What is the risk of a low capital ratio? A low capital ratio means high leverage. If assets produce negative returns, these negative returns will be magnified for the equity holders. But there is a risk greater than this.

Equity is the residual claimant in the corporate capital structure. After liabilities are paid, the remainder of cash flow goes to equity holders. This is the “cash flow waterfall.” If things go well, equity holders can make large gains. However, in financial distress, it is equity that absorbs losses. Equity is the “first loss position.”

In banking, loan defaults are a negative return on assets. If loan losses are large enough, they will completely wipe out equity capital. If value of equity equals zero, then the value of assets equals the value of liabilities. A low capital ratio means that there is a very small buffer to absorb losses. If the value of assets falls below the value of liabilities, then the firm is bankrupt. This is the definition of insolvency: the value of assets is less than the value of liabilities. This means that the bank defaults on its liabilities. This is the definition of bank failure. Therefore, low capital ratios can increase bank returns, but they also increase the probability of bank failure.

Risk Management in Banking

Risk management is a key aspect of banking. One could say that the business of banking is primarily risk management. It is also important to understand that risk management does not mean taking less risk. In some sense, good risk management allows you to take more risk. Risk management allows you to take more risk without exposing yourself to uncontrollable amounts of risk. It is knowing how close to get to the cliff without stepping off the ledge.

Another interesting analogy is downhill skiing. To win a gold medal, a skier must ski at the very limit of being out of control. This is the fastest speed, but also the highest risk. Bankers sometimes refer to “getting out over your skis,” meaning taking excessive risk. This is a form of greed and irrational exuberance in bank lending. Good risk managers know how to “push the limits” without losing control.