Commercial Banking

Commercial Banking is the backbone of the modern economy, the familiar institution on your high street or in your banking app. At its heart, a commercial bank is a financial institution that provides services like accepting Deposits, making business and consumer Loans, and offering basic investment products. This is the classic “borrow and lend” business that most people think of when they hear the word “bank.” It's fundamentally different from its swashbuckling cousin, Investment Banking, which focuses on more complex activities like underwriting Initial Public Offerings (IPOs) and advising on Mergers and Acquisitions (M&A). Commercial banks are the workhorses, not the show horses, of the financial world. They facilitate the flow of money by taking in savings from individuals and businesses and lending that money out to others who need it for things like mortgages, car loans, or starting a new venture. This process of credit creation, managed under the system of Fractional Reserve Banking, is essential for economic growth.

Imagine you open a simple grocery store. You buy apples from a farmer for €1 and sell them to customers for €1.50. Your profit is the 50-cent spread. Commercial banks operate on a similar, albeit more complex, principle. Their primary source of income is the Net Interest Margin (NIM). This is the difference between the interest they earn on their Assets (primarily loans to customers) and the interest they pay out on their Liabilities (primarily deposits from customers). For instance, a bank might pay you 1% interest on your savings account but charge a homebuyer 4% interest on their mortgage. The 3% difference is the bank's gross profit on that money. The higher the NIM, the more profitable the bank's core business is. Of course, banks have other ways to make money. They also generate non-interest income from a variety of fees:

• Monthly account maintenance fees
• Overdraft fees
• Wire transfer fees
• ATM fees for non-customers
• Fees for financial advice or wealth management services

For a value investor, a healthy mix of interest income and fee income can signal a stable and diversified business.

Warren Buffett famously said, “Banking is a very good business, unless you do dumb things.” As an investor, your job is to find the banks that aren't doing dumb things. To do this, you need to look beyond the marble columns and friendly tellers and dig into the numbers on the Balance Sheet.

• Return on Assets (ROA): This tells you how efficiently a bank is using its assets (mostly loans) to generate profit. An ROA of 1% or higher is generally considered good. It answers the question: “For every €100 in assets, how many euros of profit did the bank generate?”
• Return on Equity (ROE): This measures the return to the shareholders who own the bank. Because banks use a lot of leverage (debt), ROE is usually much higher than ROA. An ROE of 10% or more is often seen as a sign of a healthy bank. A good investor compares both; a high ROE driven by dangerously low Equity and excessive leverage is a major red flag.

• Efficiency Ratio: This simple metric shows how much it costs a bank to make a dollar of revenue. It's calculated as Non-Interest Expenses / Revenue. A lower ratio is better. If a bank has an efficiency ratio of 55%, it means it's spending 55 cents to make every dollar. A lean, well-run bank will consistently have a lower efficiency ratio than its peers.

• Non-Performing Loans (NPLs): These are loans where the borrower has stopped making payments for a specified period (usually 90 days). A rising NPL ratio is a flashing red light, indicating that the bank made poor lending decisions.
• Loan Loss Provisions: This is money a bank sets aside from its income to cover expected losses from bad loans. Think of it as a rainy-day fund for defaults. A bank that is consistently and prudently building its provisions is being conservative. One that is releasing provisions to boost short-term earnings might be heading for trouble.

Investing in banks means understanding their unique risks.

• Credit Risk: This is the biggest risk of all—the chance that borrowers won't pay back their loans. A recession or a downturn in a specific industry (like real estate or energy) can cause credit losses to spike.
• Interest Rate Risk: If interest rates set by a Central Bank (like the Federal Reserve or the European Central Bank) change unexpectedly, it can squeeze a bank's Net Interest Margin. For example, if rates on deposits rise faster than the rates the bank can charge on new loans, profits will suffer.
• Liquidity Risk: This is the classic “bank run” scenario. It’s the risk that a bank won't have enough cash on hand to meet withdrawal demands from its depositors. Fortunately, for most individual depositors in developed countries, this risk is largely mitigated by government programs like the FDIC (Federal Deposit Insurance Corporation) in the U.S. and similar Deposit Insurance Schemes across Europe.

Commercial banks can be fantastic long-term investments, but they are not risk-free. Their heavy reliance on leverage means that small mistakes in lending can lead to big losses for shareholders. A value investor should seek out simple, understandable banks with a long history of conservative lending, consistent profitability (good ROA and ROE), and low efficiency ratios. Avoid banks that are growing their loan book too aggressively or operating in exotic markets you don't understand. If a bank's business model and loan portfolio don't fit within your Circle of Competence, it's best to simply look elsewhere.