Earnings power is a key determinant of the long-term success or failure of a financial institution. It measures the ability of a bank to create economic value and, by adding to its storehouse of resources, to preserve or improve risk protection for creditors.
—Moody’s Investor Services, Bank Financial Strength Ratings: Revised Methodology, September 2006
The keys to banking are as follows: Charge high enough lending rates to cover default risk and yield a hefty profit. Leverage your capital and customer relationships by providing services . . . in areas where you have a comparative advantage. Maintain a strong enough balance sheet so that counterparty credit concerns don’t impinge on your ability to do business. Avoid businesses where you have no competitive advantage.
An examination of the composition of a bank’s earnings is an appropriate place to start a thorough analysis since the makeup of the various earnings flows conveys information about both its risk and performance profile. Different sources of earnings imply different levels of risk. In addition, an overdependency on any single source of revenue tends to make a bank more vulnerable to its sudden diminution. For instance, a bank that is heavily reliant upon commercial and industrial lending to small and medium-size firms is likely to be at a disadvantage to rivals that can draw on a number of revenue sources. Owing to its accepting higher risks, it will likely enjoy ...