A bank’s income statement · RiskAtoms Academy

By the end you will be able to

1Break a bank's profit into net interest income, fees, trading income, impairments and operating costs.
2Explain how interest income and interest expense come from the balance sheet.
3Explain why impairments rise in a downturn, and how they reduce both profit and loans.
4Tell the steady lines of a bank's income statement from the volatile ones.

Why it matters

Example Bank plc earned £21,000m of interest last year. Its shareholders ended up with £4,200m. Where did the rest go? Following every pound down the page tells you how a bank makes money, and how it could lose it.

Core explanation

From interest income to profit

A shop's income statement starts with sales. A bank has no sales in that sense. Its top line is built from the balance sheet you met in L1.8.02: every loan and bond earns interest, and every deposit and bond issued costs interest. Read the statement from the top.

1. Net interest income. Interest income minus interest expense gives net interest income (NII). Example Bank plc lends at about 5.5% and pays about 2% on deposits. The gap, earned on hundreds of billions of pounds, is the core of its business. For a retail bank, NII is usually the biggest single line. It moves with interest rates and with competition for deposits.

2. Fees and commissions. Net fee income comes from services: card payments, account packages, advice on deals, managing customers' investments. It needs little capital and tends to be steady.

3. Trading income. Net trading income comes from market making and from positions in bonds, shares, currencies and derivatives. It can be large at investment banks, and it is volatile: a good year can be followed by a loss.

Add these up and you get total operating income, the bank's version of revenue.

4. Operating costs. Operating expenses are the cost of running the bank: salaries, technology, branches, and regulatory levies. What is left is pre-impairment profit.

5. Impairments. Some borrowers will not repay. Each year the bank charges an impairment, sometimes called the credit loss expense or, in the US, the provision for credit losses. Under IFRS 9 and the US CECL standard it is based on expected credit losses, not just on loans already in default. The charge is small in good years and jumps when the economy turns.

6. Tax and profit. Tax comes off profit before tax. The rest belongs to shareholders. Some is paid out as dividends; the remainder is added to retained earnings.

Where the income statement meets the balance sheet

Interest income and expense = balance sheet amounts × interest rates.
Impairments add to the loss allowance, so net loans on the balance sheet go down.
Profit, less dividends, adds to retained earnings. Example Bank plc made £4,200m, paid £2,200m in dividends and kept £2,000m.

Sort itWhich line?

0 / 6 right

Each item is something that happened at a bank during the year. Which line of the income statement does it go in?

Monthly interest paid by customers on their mortgages.
Interest credited to customers' savings accounts.
Charges paid by shops when customers pay by card.
Profit from buying and selling bonds for clients during the day.
Salaries of the bank's software engineers.
A charge because more small businesses are expected to default next year.

The formal version

The statement is a chain of subtractions. Start with the top-level line and expand one part at a time:

\text{Profit} = \text{Profit before tax} - \text{Tax}

\text{Profit before tax} = \text{Operating income} - \text{Operating costs} - \text{Impairments}

\text{Operating income} = \text{NII} + \text{Fees} + \text{Trading} + \text{Other income}

\text{NII} = \sum_{\text{assets}} \text{balance} \times \text{rate} \; - \sum_{\text{liabilities}} \text{balance} \times \text{rate}

The $\sum$ sign means “add up over every line”, as in L1.4.03. The balances are averages over the year, because a loan made in June only earns interest for half the year.

Try it

The waterfall below is Example Bank plc's income statement. Hover over or tap a bar to see what it is. Then raise the deposit rate by one percentage point: how much profit is lost? Now push impairments up until profit before tax reaches zero.

Try itExample Bank plc: the profit waterfall

£ million, one year

Average rate on loans5.50%

Average rate paid on deposits2.00%

Impairments, % of loans0.40%

Operating expenses£8,200m

Net interest income. Interest income minus interest expense: the spread business.

Profit for the year

£4,200m

Net interest income, share of operating income

70.0%

Impairments, share of pre-impairment profit

17.6%

Worked example

Building Example Bank plc's income statement

Example Bank plc holds on average £300,000m of loans at 5.5% and £150,000m of cash and securities at 3%. It pays 2% on £330,000m of deposits, 4.5% on £80,000m of wholesale funding and 3.75% on £8,000m of subordinated debt. All rates are annual. Work down the page, trying each step first.

From balances to profit

Step 1 of 7

1
Interest income
£16,500m from loans + £4,500m from cash and securities = £21,000m.

Two sensitivities fall out of it. If the bank had to pay 1 percentage point more on all its deposits, NII would fall by £3,300m. And its £6,800m of pre-impairment profit can absorb impairments of up to 2.27% of loans in a year before profit before tax hits zero.

Here is how a bad year reaches the balance sheet. Suppose a recession costs Example Bank plc an extra 1% of its loans, £3.0bn, on top of the normal charge. Set the loan loss slider to 1% and watch loans, retained earnings and return on equity.

Interactive balance sheetExample Bank plc

£ billion, year end

Return on equity here is the year's profit of £4.2bn, less any extra loss, divided by equity. Tax relief on the loss is ignored. At 1% it falls to 4.4%.

Assets · £500.0bn

Liabilities and equity · £500.0bn

assets liabilities equityDashed outline: size before any shock.

Assets: what it owns

Total assets£500.0bn

Liabilities and equity: how it is funded

Liabilities
Wholesale funding£80.0bn
Equity

Total liabilities and equity£500.0bn

Cash and central bank reservesasset · 10.0% of total assets

Notes and coins, plus the bank's account at the central bank. The most liquid asset there is.

Risk to watch: Liquidity: this is what pays depositors who withdraw on a bad day.

Apply a shock

Loan losses0.0%

Share of loans written off as borrowers default.

Loss charged to equity

£0.0bn

Equity

£30.0bn → £30.0bn

Share of equity lost

0.0%

Return on equity

14.0%

Profit after the shock ÷ equity. Ignores tax.

Equity ÷ assets

6.0%

How much of the balance sheet the owners fund.

Regulatory lens · looking ahead

The impairment line follows IFRS 9 (expected credit losses in three stages) or, in the US, CECL (lifetime expected losses from day one). Both are covered in later levels. Supervisors' stress tests, such as those run by the Bank of England, the Federal Reserve and the European Banking Authority, project exactly these lines (NII, fees, costs and impairments) through a severe recession, to see whether capital would hold up.

Sparks

SparkToo little, too late

Before 2018, IFRS banks recognised a loan loss only once there was evidence it had already been incurred. After the 2008 crisis, critics, including G20 leaders, said this left provisions “too little, too late”. IFRS 9 and, in the US, CECL replaced it with expected losses, so provisions now rise as soon as the outlook worsens, before borrowers miss payments.

SparkWhen rates rise, margins can widen

Rising interest rates often help a bank's NII at first: loan rates reset quickly, while many deposit rates follow slowly. Push the deposit-rate slider down and the loan-rate slider up to see the effect. But the same rise can cut the value of the bank's bond holdings, and squeeze borrowers.

Key takeaways

A bank's income statement runs: NII, plus fees and trading income, minus operating costs, minus impairments, minus tax.
NII is interest earned on assets minus interest paid on liabilities, so it is built from the balance sheet.
Fees tend to be steady; trading income and impairments swing the most.
Impairments are expected credit losses: they cut profit and build the loss allowance that reduces net loans.
Pre-impairment profit is the first buffer against loan losses, before equity is touched.

Reaction

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Glossary

Net interest income: Interest earned on loans and securities minus interest paid on deposits and borrowing.
Net fee income: Income from services: account and card fees, payments, advice, managing funds. Shown net of fees the bank pays.
Net trading income: Gains and losses from buying and selling securities and derivatives, including market making for clients.
Operating income: Net interest income plus all other income. The figure a bank uses where a company would show revenue.
Operating expenses: The costs of running the bank: staff, technology, property, marketing and regulatory levies.
Pre-impairment profit: Operating income minus operating costs, before impairments. The first buffer against loan losses.
Impairment: The charge for credit losses the bank expects on its loans. It increases the loss allowance and reduces profit.
Expected credit loss: Expected credit loss: the probability-weighted loss a bank expects on a loan, used by IFRS 9 and CECL.
Cost of risk: Impairments for the year as a percentage of loans.

Deep Dives & Origins

Deep Dives

Saunders and Cornett, Financial Institutions Management: A Risk Management Approach (McGraw-Hill), the chapter on financial statements and performance of depository institutions. Intermediate.
Hull, Risk Management and Financial Institutions (Wiley), the chapter on banks. Intermediate.

Origins

IASB, IFRS 9 Financial Instruments (2014), section 5.5 on impairment.
FASB, Accounting Standards Update 2016-13, Financial Instruments: Credit Losses (Topic 326) (CECL).
Financial Stability Forum, Report on Addressing Procyclicality in the Financial System (April 2009).

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