The business model is simple. Banks lend money from what they collect or deposit. So, it is logical to think that the customer deposit is the most important factor for the bank. What about another source of revenue? Isn’t it matters? What does another factor investors need to consider to understand – and in turn, make valuation for the bank industry? Here, through our financial analysis for the Banking industry, we try to elaborate on that question.
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In This Issue
By its own nature, banks enjoy a significant economic moat (sustainable business advantage). They are a government partner to transmit the monetary policy – thus, their collapse means a disaster for the whole economy. Fun fact, four out of ten largest bails out by the Federal government are the banks (cough, congrats taxpayer). In this analysis, we take JP Morgan as a real-life example. It operates in both conventional and unconventional ways. They have a commercial segment, the bank we know. And the investment or corporate bank – segment that is less familiar with us. JP Morgan will serve as a near-perfect example.
Here are several issues we deal with:
We begin the chapter with the most primitive business model for the banks. It collects money from people, pays them with a certain interest rate, then lends that money to another – charges them with the higher rate1.
The economic principle remain holds true in every business – that is, to produce the good or to deliver service with the lowest cost material. The bank is no exception for that adage. For them, the “raw material” is customer deposit.
Cost of Good Sold
The more banks collect, the more they can distribute, the more profit they earned. Thus, the Bank’s pursuit of customer deposits plays a crucial role in its profitability.
To gain deposits from people, banks need to build trust. This is why banks design their branch carefully and aesthetically – to make an impression once you enter the building. This is why they employ good-looking people – to make you stay longer, listening to their marketing. They should (hopefully they are) look dependable, reliable, warm, kind. banks need you to…OK, I put my money here.
Regarding deposits, In the financial statement, investors could check this item in its balance sheet under the liability section.
Real-life Case to Financial Analysis For Banking Industry: Trust in Storm.
When we ask about trust, the extreme case will tell the truth. During the last year’s pandemics, when another business was “locked” down and the money was “drained”, US banks were flooded by an additional record 2 trillion in the deposit account. We believe that this phenomenon is driven by fear, uncertainty, and risk aversion.
And it is no surprise that this large amount of money was concentrated only on big-name – JP Morgan Chase get the largest stream. When the circumstances are in question, unstable, you need something that you could……trust (Though, the record in deposit didn’t make JP Morgan generate more revenue)
Real-life Case fo Financial Analysis For Banking Industry: Scale. Moat
For JP Morgan, the commercial segment is held under the name Chase Bank. They have impressive numbers – 5,000 branches, 16,000 ATMs. Moreover, they also possess more than 50% of United States households as their customer. This dinosaur scale help company to deliver more than 64 Billion in revenue (down from 2019 with 84 Billion due to COVID-19)
Real-life Case fo Financial Analysis For Banking Industry: The Debt Deliver
Ok, now with all pool of money JP Morgan has, the task is done, right? We just offer this money to people who need it, a business that expands their branch, a single mother that plans to grow a business at home, a teen to go to college…
Not so easy.
Even with all the power, it has – the tech, the pool of money, government backup – the bank can’t lend the money carelessly.
The fact is, not all businesses could pay – somehow, many of them will end in a fail, trapped in bankruptcy. Your debtor may face financial problems, she may lose the job and has no capability to pay the debt. For that reason, banks need to be prudent. They need to be selective – they need to take care of the quality of the debt.
There are several methods to track these things, One of our favorite matrices is net charges-off. This metric shows you how much debt is left unpaid by the debtor. The higher the number, means the more terrible bank is in distributing its money. Last year, JP Morgan could maintain this number even under pandemic tension. The net charge-off surged in the first and second quarter then flattened in the next periods. No complacency, but this is a positive sign that JP Morgan is prudent to distribute its money.
To know more about how banks handle the debt they deliver, we make an analysis for Bank of America which you can read here.
It is not a Bank
Another segment of JP Morgan’s business is an investment & corporate bank. It isn’t actually a bank. Corporate and Investment Bank or segment doesn’t collect money from people and makes deposits. No ATM, no debit cards, no cheques. In 2020, these segments contribute almost 50 Billion in revenue and more than 17 Billion in earnings.
Unlike the customer and community bank (the first kind of bank that we have discussed), the corporate and investment bank’s main role is to raise capital for corporate (as the name implies) or companies – whether through bonds or Initial Public Offerings. Here is the explanation of several methods investment banks employ to generates money.
Investor Seeker: Bond Market
Suppose you are Walmart CEO – your business is eroded by Amazon expansion and needs to survive. To do so, you plan to build a new factory – to manufacture your own product and fight Amazon back. Since building a new factory is super expensive, You decide to come to the bank and request a loan.
The bank assesses your business is in the downturn, thus they charge a high interest rate, say, 10%. You don’t like this scheme, so instead of asking the bank, you asking the public – they may have a different opinion than the bank. Here the investment bank participates.
The investment bank helps you and your company to issue a debt bond with an interest rate lower than the bank charge, let’s say 8%. And if your bond is higher than the deposit rate, suppose we have a 5% deposit rate, it will be A win-win solution. the public could get a higher interest rate than the deposit rate in the bank, and you get the capital needed with lower interest.
To deploy your debt bond, JP Morgan charges a fee.
The Stock Market
Another way to raise capital is through the equity market. Imagine you are the CEO of a high-tech start-up operate in water salination. You need a lot of money to expand your business, everyone needs water, huh? You can’t request a loan since it has reached the limit for your business. So, you come to JP Morgan and seek advice.
Since your business is fast-growing, promising, and has credibility – JP Morgan advises you to go public – make your ticker in the stock exchange – NYSE: YOU. If you agree, JP Morgan will issue shares on behalf of your company. An investor who interests in your business will buy shares and you get the capital you needed.
The advantage for you using this method is less pressure – no interest to pay, no payment date. The disadvantage is, now you “share” your ownership of the company with others. A portion of the earnings you generate will be theirs.
JP Morgan makes money from this service.
Merger and Acquisition
Sometimes, the company can’t rely solely on organic growth. They need to join the strength with another company – like Exxon and Mobil, or Dew Chemical and Du Pont. Or, they could take another smaller company under its subsidiary, like Disney acquire Pixar or Google take over Youtube.
JP Morgan offers services for advice and performing the merger and acquisition.
The beauty of the financial world is everything is on sale.
A secondary market is a place for you and me.
Back to our first illustration, when you as CEO of a water treatment company issue shares to raise capital. Suppose an investor – Miss Alba, holds 100 shares of your company. She bought it at IPO price, 300 for instance. Far away from Miss Alba’s house, Mrs. Jenner – an environmental engineer in a reputable company – is interested in your company. She opens her trading desk and checks your ticker, NYSE: YOU, now the price is at 400. Since she is an expert in water treatment and has basic accounting knowledge, she doesn’t mind paying this price. And if an investor like Miss Alba is willing to sell the whole of her ownership to Miss Jenner, the transaction happens. Mrs. Jenner bought the shares for 40,000.
JP Morgan, as an intermediary of both parties, charges the buyer and the seller in this transaction.
Besides those two segments, JP Morgan also has another: commercial banking, asset, and wealth management – but the contribution to revenue and earnings is not as significant as the customer and corporate segments. We will cover them someday.
TLDR: Key Takeaway of Financial Analysis for Banking Industry
- A company could do so many things just to become intermediate parties – banks are one of this kind of business.
- While the deposit is vital for the bank since it could be circulated to deliver more revenue for the bank, the non-interest revenue can’t be overlooked. Non-interest revenue plays as a cushion when the rate to volatile or when the economy faces a challenge. It makes the bank more stable. Non-interest revenue can emerge from IPO fees, secondary market transaction fees, bond issuance fees,s or any financial service that does not involve interest.
- We love to invest in banks, they have an intangible asset as an economic moat: they are protected in government castles. They enjoy switching costs, and in several cases like JP Morgan – they enjoy economies of scale.
- As usual, we talk about risk, risk, and risk. The risk for the bank comes from its credit. The investor should pay serious attention to it. This is why – once again – that non-interest revenue is vital. It is the revenue that has no risk.
- We don’t discuss investor metrics – yet. About ROE, ROIC, Net Interest Margin. We present you the most basic – and the most important ones before you go to valuation and metrics. It is just a number, it is useless otherwise you understand the business.
Have great analysis. We have chapter 2 awaiting.
- actually the mechanism is more complex than that, but for the sake of simplicity, let’s go on [↩]