What is a bank?
A bank is a licensed financial institution that accepts deposits, safeguards cash, and lends money to individuals and businesses. Banks act as intermediaries: they take in customer deposits, pay depositors some interest, and use much of those funds to make loans that earn higher interest. In addition to deposit and loan accounts, many banks offer products such as individual retirement accounts (IRAs), certificates of deposit (CDs), currency exchange, and safe-deposit boxes.
A brief historical note
The core business model—taking deposits and making loans—has existed for centuries. Early modern banks (for example, those associated with the Medici family) developed many of the practices that persist today, even as the menu of bank products has expanded.
Key products and what they mean
– Checking account: A deposit account for day‑to‑day payments and withdrawals. These accounts usually pay little or no interest and may charge monthly or transaction fees. Many people receive paychecks and recurring payments directly into checking accounts.
– Savings account: A deposit account that pays interest to the depositor. Rates are typically modest; savers choose among regular savings for liquidity or higher‑yield options like certificates of deposit (CDs) by locking funds for a set term.
– Certificate of deposit (CD): A time deposit that pays a higher interest rate in exchange for keeping money in the account for a fixed period (from a few months to several years).
– Loan services: Banks issue loans—mortgages, auto loans, business loans, credit cards—using deposited funds. The interest charged on loans exceeds the interest paid on deposits; that difference is a primary source of profit.
How banks make money (simple formula)
Net interest margin (simplified) = Interest rate on loans − Interest rate on deposits.
Worked numeric example (simplified)
Assume a bank pays 1.0% annual interest on deposits and charges 6.0% on a mortgage.
– Interest spread = 6.0% − 1.0% = 5.0%
– If the bank lends $100,000 funded by deposits, gross interest income (before operating costs, loan losses, taxes) = $100,000 × 5.0% = $5,000 per year.
Note: This is a simplified illustration. Real banks face funding costs, operating expenses, regulatory capital requirements, and the risk of borrower defaults, all of which reduce net profit.
Types of banks
– Retail banks: Serve individual consumers and small businesses with checking/savings accounts, consumer loans, mortgages, credit cards, and often investment and wealth management products.
– Commercial (corporate) banks: Focus on services for businesses, such as commercial lending, cash management, and treasury services.
– Investment banks: Provide capital markets services, underwriting, mergers and acquisitions advisory, and trading for corporations and institutional clients.
– Central banks:
Central banks: Central banks are national monetary authorities that manage a country’s money supply, interest rates, and financial-system stability. Primary roles include conducting monetary policy (e.g., setting benchmark interest rates and open-market operations), acting as lender of last resort to solvent banks in distress, issuing legal tender (currency), and supervising or coordinating bank regulation. Examples include the U.S. Federal Reserve, the European Central Bank, the Bank of England, and others.
Other bank types and ownership forms
– Savings banks and thrifts: Historically focused on retail deposits and mortgage lending.
– Cooperative and mutual banks: Customer-owned institutions that return profits to members or reinvest in services.
– Online-only banks and neobanks: Provide banking services primarily via digital platforms; often have lower overhead and different funding mixes.
– Shadow banking entities: Nonbank financial intermediaries (e.g., finance companies, money market funds) that perform bank-like functions without full bank regulation.
Core bank functions (short checklist)
1. Accept deposits (payment and savings vehicles).
2. Make loans and investments (credit intermediation).
3. Provide payment and settlement services (clearing checks, transfers, card processing).
4. Transform maturities and liquidity (borrow short-term deposits, lend long-term).
5. Manage risks (credit, market, liquidity, operational).
How banks earn profits (brief)
– Net interest income: difference between interest earned on assets (loans, securities) and interest paid on liabilities (deposits, borrowings).
– Noninterest income: fees (account fees, card fees), trading income, advisory and investment-banking fees.
– Costs and losses: operating expenses, loan-loss provisions for defaults, taxes, and regulatory costs reduce profit.
Key performance metrics — definitions, formulas, and worked examples
1. Net Interest Margin (NIM) — measures the spread earned on interest-bearing assets.
Formula: NIM = (Interest Income − Interest Expense) / Average Earning Assets.
Worked example: Interest income = $5,000; interest expense = $500; average earning assets = $100,000.
NIM = (5,000 − 500) / 100,000 = 0.045 = 4.5%.
2. Return on Assets (ROA) — how efficiently a bank uses assets to generate profit.
Formula: ROA = Net Income / Average Total Assets.
Worked example: Net income = $2,000; average assets = $120,000.
ROA = 2,000 / 120,000 = 0.0167 = 1.67%.
3. Return on Equity (ROE) — return to shareholders.
Formula: ROE = Net Income / Average Equity.
Worked example: Net income = $2,000; average equity = $10,000.
ROE = 2,000 / 10,000 = 0.20 = 20%. (High ROE can reflect high leverage.)
4. Loan-to-Deposit Ratio (LDR) — funding mix and liquidity posture.
Formula: LDR = Total Loans / Total Deposits.
Worked example: Loans = $100,000; deposits = $120,000.
LDR = 100,000 / 120,000 = 0.833 = 83.3%.
5. Common Equity Tier 1 (CET1) Ratio — core capital strength under Basel rules.
Formula: CET1 Ratio = Common Equity Tier 1 Capital / Risk-Weighted Assets.
Worked example: CET1 = $10,000; risk-weighted assets = $80,000.
CET1 = 10,000 / 80,000 = 0.125 = 12.5%.
Notes on these metrics
– “Average” in formulas normally uses beginning and ending balances (or more frequent averages) to smooth seasonality.
– Risk
– Risk-weighted assets (RWA) assign different regulatory weights to asset categories (for example, cash = 0%, sovereign debt = low weight, unsecured consumer loans = higher weight). When you calculate ratios that use RWA (CET1, total capital ratios), be sure you’re using the same RWA definition as the regulator or disclosure (local rules and Basel implementations differ).
Other practical notes on bank metrics
– Use averages where possible. Quarterly or monthly averages of balances reduce seasonality and reporting-date distortions.
– Watch off-balance-sheet items. Guarantees, letters of credit, securitizations and unused commitments can materially affect risk and funding but may not appear in headline balance-sheet totals.
– One-offs and accounting policy changes matter. Large sale gains, merger charges, or reserve-policy shifts can move profitability and coverage ratios temporarily.
– Compare like with like. Different accounting standards (IFRS vs. US GAAP), regulatory add-ons, and business models (retail vs. investment banking) change what “good” looks like.
– Trend and peer analysis beat single-point checks. A stable 10% CET1 that’s falling over several quarters is a bigger red flag than a single low quarter.
Additional common bank ratios (formulas, definitions, numeric examples)
1) Nonperforming Loan Ratio (NPL ratio)
– Definition: share of loans that are not current (typically 90+ days past due or impaired).
– Formula: NPL ratio = Nonperforming loans / Total loans.
– Worked example: Nonperforming loans = $3,000; Total loans = $100,000. NPL ratio = 3,000 / 100,000 = 0.03 = 3%.
– Use: gauges asset quality; rising NPLs suggest stress in the loan book.
2) Allowance Coverage Ratio (Loan-loss reserve coverage)
– Definition: how well the loan-loss reserve (allowance for credit losses) covers loans already classified as nonperforming.
– Formula: Coverage = Allowance for credit losses / Nonperforming loans.
– Worked example: Allowance = $600; Nonperforming loans = $3,000. Coverage = 600 / 3,000 = 0.20 = 20%.
– Use: low coverage can mean higher potential future losses; high coverage reduces near-term earnings volatility.
3) Net Interest Margin (NIM)
– Definition: the percentage margin the bank earns on its earning assets (interest income net of interest expense), a core measure of banking profitability.
– Formula: NIM = (Interest income − Interest expense) / Average earning assets.
– Worked example: Interest income = $6,000; Interest expense = $1,500; Avg earning assets = $90,000. NIM = (6,000 − 1,500) / 90,000 = 4,500 / 90,000 = 0.05 = 5%.
– Use: higher NIM usually improves pretax earnings; interest-rate cycles and asset mix (loans vs. securities) drive NIM.
4) Efficiency Ratio (Cost-to-Income Ratio)
– Definition: operating cost per dollar of income; lower is generally better.
– Formula: Efficiency ratio = Noninterest (operating) expenses / (Net interest income + Noninterest income).
– Worked example: Noninterest expense = $4,000