Objectives:

At the end of this chapter, students will be able to:

1. Explain the importance of Equity-Asset Ratio and Loan-Deposit Ratio.

2. Describe the Income-generating Process in a bank.
3. Identify the sources of income to a bank.
4. Explain the types of income generated from each sources.
5. Explain the concept and the importance of NIM in bank management.
6. Draw a conclusion about the general principles on how banks make money.

Bank Size and Share of Market

The following table shows statistics on the percentage of large, medium and small US banks and
their shares of the market in 2002.
Table 1: Size & share of assets of US banks in 2002

Size % of Total Banks % of Total Assets

Large banks 5.1% 84.7%

Medium banks 42% 12.35
Small banks 52.8% 3%
Source: Rose & Hudgins

The above Table tells us that in 2002, large or big banks made up of only 5.1% of all banks in
USA. Yet, large banks controls 84.7% of banking market. Majority of the banks in USA in 2002
was small and medium banks. Together they make up 94.8% of all the banks. Small banks were
largest in number, accounting for 52.8%, but they only share 3 of banking market. Today, this
pattern is also applicable in banking industry worldwide. Since 1990, large banks in USA,
Europe and Japan engaged in cross-border mergers. Today, a handful of large, international
banks dominate substantial portion of banking business in the world.

Equity/Asset Ratio and Loan/Deposit Ratio

Banks use many financial ratios to make banking judgment, measure performance and compare
financial achievement. We now introduce two of the ratios namely Equity-Asset Ratio and Loan-
Deposit Ratio to partly demonstrate how banks are managed. Table below gives these two ratios
on the 6 largest banks in USA in 2003.
Table 2: Equity-Asset Ratio and Loan-Deposit Ratio on Six Largest Banks in USA, 2003

Equity-Asset Ratio shows how much bank owners put in the bank as capital to generate the
assets. This ratio gives 3 indications:

a. Efficiency -it tells how efficient is the banks management in using the owners capital to
generate the assets. From the above Table, Bank One is most efficient, followed by First
Union and Citibank. Bank One uses the least amount of equity (6.83%) to generate its
assets. US Bank is the least efficient.

b. Capability to absorb losses One of the functions of bank capital is to absorb losses.
Thus, Equity-Asset Ratio tells how much loss is the bank able to absorb before the bank
is declared bankrupt. A bankrupt bank causes great suffering to the depositors, debt-
holders and the countrys economy. From the above Table, US Bank has the highest
capability. On the other hand, Bank One has the lowest capability, followed by First
 Union and Citibank. This is exactly the opposite of their status in (a) above. What it
means is very simple: Bank One is the most efficient bank to the owners. However, it is
worst in providing protection to the depositors, debt-holder (people who lend money to
the bank, such as bond holders) and to the economy. The lower ratios signal danger or
risk, which brings us to the third indicator of Equity-Asset Ratio.

c. Risk It tells how risky the bank is to the general public (depositors, debt-holders,
customers, etc.) Bank One is the riskiest to general public. It probably has a very small
amount of capital and it leverages on the public money to create assets. At Equity-Asset
Ratio of 6.83%, Bank One must have used 93.17% (100%-6.83%) of public money to
generate assets for the banks owners. Most of the public money belongs to the depositors
(averaging 70% of banks asset). So, in case Bank One incurs big loss that can lead to
bankruptcy, depositors and debt-holders shoulder 93.17% of the loss, leaving the owners
to shoulder only 6.83% of the loss. However, in case of profit, owners get the most of the
net profit and 100% of the assets. For this reason, banks are now required to have a
minimum capital of 10% of total risky assets. This requirement is known as the Basel
Capital Requirement, which students will learn more in the higher-level banking courses
at UUM.

Now, let us see what the Loan-Deposit Ratio means to the bank and to the depositors. Keep
in mind that, from Table above, bank owners supply very little capital to their banks. The
bulk of the money that the banks use to generate assets and profits comes from the
depositors.

The Loan-Deposit Ratio (L/D Ratio) gives two indications:

a. Liquidity position it tells us how much of the customers deposit do banks keep in cash
and near-cash to meet liquidity needs, and how much is lent out to generate assets and
profits. Bank One lent out 77.9% of depositors money, which means Bank One only
keeps 22.1% of the deposits in cash and near cash to meet customers withdrawal, pay
short-term obligation, etc. Here, Bank One is 22.1% liquid and it is the most liquid bank
among the 6 banks in the above Table. US Bank is the least liquid bank. At L/D Ratio of
106.5%, US Bank lent out all the depositors money plus the borrowed funds from other
sources. US Bank is said to be Over Trading. Thus, the ratio reflects another indication -
bank managements attitude towards risk.

b. Risk appetite - higher L/D Ratio indicates that the management has high-risk appetite
and has engaged in aggressive lending strategy. As a rule of thumb, during a stable
economic condition, a safe L/D Ratio should not exceed 80% level. Anything above 80%
is overtrading (trading beyond own ability) and is exposing the bank to great jeopardy. In
1997 Asian Financial Crisis, many banks in Malaysia with L/D Ratios between 120%
140% collapsed as the economy took a sudden downturn.
New regulations were introduced to prevent the banks from engaging in overtrading. Some like
the Basel III Capital Requirement now requires banks to maintain a minimum Liquidity Ratio.
Guidelines on Corporate Governance also require the banks directors to properly manage their
banks exposure to risks. You will learn more about these and other regulations later in your B.
Banking (with Hons.) program.

Income Generating Process

To see the process, let us turn our attention to the following Table, which summarizes the
components of assets and liabilities of all banks in Malaysia as at end of 2015
Table 3: Summarized Balance Sheet of All Malaysian Banks As At 31 December 2015

All Malaysian Banks As At 31 Dec. 2015 RM mil %

Asset:
Cash & cash equivalent 3,731.04 1.3
Deposits, reserve, & Repo 4,296.55 1.5
Statutory Reserve with BNM 5,866.95 2.1
Negotiable Instruments of Deposit (NID) 7,334.34 2.6
Total receivable 32,620.59 11.7
Msian securities T-Bills, MGS, Trading Securities 36,850.29 13.2
Loans & Advances 164,608.82 59.2
Fixed assets & other assets 23,472.88 8.4

278,781.52 100%

Equity & Liabilities:

Total equities (Capital & reserve) 28,346.30 10.2
Total deposits 201,010.22 72.1
Debts, liabilities & bills payable 49,424.99 17.7

278,781.52 100%
From the above Table, shareholders (owners of the banks) contributed only 10.2% of total
liabilities as capital. The banks used deposits (about 72%) from general public and debts (about
18%) borrowed from various sources to generate assets and profits.

Specifically, the banks used 60% of the liabilities to create loans, 17% to create investment, 10%
to create other assets and kept 16% in cash to meet liquidity needs. The conversion of liabilities
into assets is reflected in the following Figures
 Figure 1: How Liabilities Are Used To Generate Assets

The above figure gives a mind-mapping picture on how liabilities are converted into assets.
These assets generate incomes in various forms interest incomes, fees, commissions, charges
and profits. Do you know how do these incomes differ from each other? Can you define them?

Defining Interest income, fees, commission, profits and charges

It is important to know why banks classify incomes into various categories or refer to them with
different names. We shall now explore by way of definition, as follows:

a. Interest incomes: these are incomes derived from interest that the banks charge on loans
and advances.

b. Fees are the financial charges the banks levied on certain services given to customers.
Examples of fees are processing fees on loan-applications, and maintenance fee on
current account for customers.

c. Commissions these are charges the bank levy on certain other services given to
customers. For examples, commission on issuing bank drafts, letter of credit, Bank
Guarantee and commission for collecting payments on behalf of banks customers.

d. Profits on Foreign Exchange (FX) these are the profits earned on transactions related to
selling and buying foreign currencies. For instance, the bank buys Euro100 from you for
RM400 and sells that Euro100 to another person for RM410, thus making a RM10 profit
on selling that Euro currency.

e. Charges are levied on customers to recover the costs the bank incur when serving them.
For example the phone and telegraphic costs when sending customers money by
telegraphic means. In levying the charges, banks do not charge more than what they
incur. Banks merely recover whatever costs they have incurred.
Having defined the different types of income, let us identify the sources of these incomes and
how each source generates incomes to the bank.

Sources of income
Banks earn income from several sources, as shown in the following figure
Figure 2: Sources and Types Of Income To The Banks

Incomes from Loan

Loans & Advances are on-balance sheet assets or items. Thus, every ringgit the bank gives out
in the form of a loan shows up on the balance sheet. The loans and advances are earning assets
to the bank, since they earn income for the bank. The income is derived from interest the bank
charges on the loan. For this reason the income on loans and advances are called interest income.
The bank earns interest income as long as the borrowers service the loans or keep the repayment
regularly. Once the borrowers default on the repayment or settlement of a loan the bank loses the
opportunity to earn interest income. Loans that are in default for more than 3 months are known
as non-performing loans and are classified as impaired loans.

Interest Income:
Fixed-Rate Interest banks charge fixed interest rate, such as 7% p.a. on a loan throughout the
borrowing period. The 7% rate remains the same although the banks Base Rate (BR) may have
changed. This 7% rate includes the BR + Spread. If you take a fixed-rate loan, your monthly
instalments remain the same even though interest rate in the market goes up or down
Floating-Rate such rate where the spread remains but the BR changes in response to changes in
the market rate.

Example: Assume, at time of giving loan, BR is 5% p.a , rises to 6% in year 2 and decreases to
4% in year 3. Assume further that the bank charges a spread of 1.5%. The borrower pays:

A time of giving loan: BR + 1.5% = 5% + 1.5% = 6.5%

Year 2 BR + 1.5% = 6% + 1.5% = 7.5%

Year 3` BR + 1.5% = 4% + 1.5% = 5.5%

In the above case, the spread remains but the rate on the loan changes from 6.5% to 7.5% and
to5.5%. BR represents the banks Cost of Funds. It covers the following costs:

Statutory Reserve Requirement (SRR), interest paid to depositors, insurance premium

paid
to MDIC and administrative costs to acquire and manage the deposits. Further discussion
on
BR and spread is given in Chapter 10 on Pricing Mechanism in Banking.

If you take a floating-rate loan, your monthly instalments will increase whenever market interest
rate increases. Likewise, you monthly instalments will decrease whenever market interest rate
falls.

Processing Fees:
Banks do charge fee for processing loan applications. The fees are normally small, ranging from
RM50 on small, retail loans to several thousands of ringgit on the bigger loans. Due to stiff
competitions, banks do waive processing fees on loan applications from their good business
clients. For this and the above reasons, processing fees make up a small proportion of income to
the banks.

Commitment fee on overdraft (OD) facility

This is fee that the borrower has to pay for not using OD facility. This fee is to help the bank
recover the cost of fund that the bank incurs for committing or making the money available for
the borrower to use. As banks always monitor OD facilities and encourage the borrowers to use
them, commitment fees make up a small proportion of income to the banks.
Income from Investment
Remember, banks invest some of their cash into near-money assets to stay liquid and, at the same
time, earn interest-incomes or profits (on Islamic financial instruments). Banks investment
portfolios can be divided into

a. Short-term investment investing short-term Fixed Deposit with another bank, or in

money-market instruments, such as negotiable instruments of deposits (NID) Bankers
Acceptances (Bas), Treasury Bills (MTB), commercial papers and Repo.
b. Medium to Long-term investments investing in long-term fixed deposits with other
banks or investing in capital-market instruments, such as bonds, notes, MGS,
Government Islamic Instruments (GII) and trading securities (shares quoted on Bursa
Malaysia).
Both the short- and the long-term investments generate interest incomes, profits (on Islamic
instruments), and dividends (on trading securities).for the banks. .Banks also earn capital gains
on their investments. This happens when banks sell the financial instruments at higher than the
purchase prices before the instruments mature.

Income from Receivables

Receivables are money that the banks will receive from various domestic and foreign sources.
Some receivables are for the services that allow the bank to charge commissions.

For example, assume:

a. In a year, Public Bank purchases bank drafts issued by various banks amounting to
RM900 million.

b. Public Bank charges 0.5% commission on these drafts.

c. On average, Public Bank takes 14 days to recovers the money (i.e., to get
reimbursement)

Total commission receive will be:

Commission = RM900,000,000 x 14 x 0.5

365 x 100

= RM172,602.74

Some receivables are for the services that allow the bank to recover its costs. For example, the
bank acts as agent for the local exporter to collect payment from the overseas importer. The bank
incurs costs, such as postage, telephone charges and charges for sending SWIFT messages. The
bank is allowed to recover these costs from the customers.

Some receivables are for the services that allow the bank to earn interest incomes. For example,
CIMB Bank discounts an export bills (for its customer) for 60 days and charge interest at 7.5%
p.a.. If the total export bills amount to RM10 billion in a year, and the average discounting
period is 90 days, CIMB Bank will earn interest income of

Interest Income = RM10 billion x 60 x 7.5

365 x 100

= RM123,287,671.20

Interest incomes form the biggest portion of banks incomes.

Incomes from Services

These incomes are from charges that banks levy on various services given to their customers.
The incomes take in the form of commissions, charges and profits. The following figure shows
the commissions earned by types of services from daily banking operation
Figure 3: Commissions & Charges By Types of Banking Services

From the figure above, banks provide payment services by selling drafts, transfer money by
telegraphic means (TT), online-transfer, etc. in so doing, banks charge commissions. Banks also
earn commissions by offering Off-Balance Sheet facilities, such as issuing letters of credit and
bank guarantees. Banks can also earn commissions by selling financial products, such as
insurance policies and mutual fund products.
From foreign exchange and derivative activities, banks earn a lot of commissions, profits and
interest-incomes. This is depicted in the following figure

Figure 4: Incomes from Foreign Exchange and Derivative Transactions.

Net Interest Margin (NIM)

Net Interest Margin (NIM) is a concept used to measure the ability of the banks management in
creating earning assets to generate interest income. Recall that Loans & Advances make-up
about 60% of total asset to the bank. Naturally interest income is the biggest source of income to
the bank. For instance, in 2014, 77% of net income at Public Bank Bhd. came from interest-
income, Only 22% of its net income came from other sources. This is summarized in Table
below. Therefore, banks profit is largely dependent on interest income.

Table 4: Net Income and Other Operating Income, Public Bank Bhd

2014 %
RM000
Net interest income 6,761,669 77%
Other operating income 1,911,688 22%
Financial Report of Public Bank FY 2014

. The formula for calculating the NIM is as follows

Net Interest Margin (NIM) = Interest Income - Int. Expenses

Total Interest-Earning Assets
From the above formula, NIM will depend, not just on interest income, but also on interest
expenses. Thus, NIM also requires that bank management should use the low-interest deposits to
funds the loans in order to increase NIM (i.e., maximize profit). Thus, NIM reflects the
management ability to increase the shareholders wealth. Shareholders and investors, therefore,
watch closely the trend in NIM to see whether the bank offers good prospect for them to invest

Apart from loans & advances, earning-assets also include investments in deposits (placed with
other banks), Repos and Trading Shares. These assets produce interest incomes (or dividend, in
case of trading share) to the bank. Note from table below that, in 2015, Public Bank earned
RM15.23 billion on interest-income as against RM7.84 billion on interest expense.

Earlier, in 2014, Public Bank made NIM of 2.1, which was lower than 2.2 it made in 2013.