A deep understanding of bank profit and loss statements ("P&L's") leads us to what is ultimately what is most important to a bank and that is profitability. A community bank is often tied to one major source of revenue, which is derived by generating revenue producing assets (loans primarily). However, as it relates to the P&L there is more to the equation as the expense associated with the deposit franchise is considered. Success or failure of a bank can often be tied to only a couple of line items from the P&L, which will be discussed here.
The Bank P&L: Income SourcesIncome sources for community and regional banks are often limited to net interest margin businesses, which are generally lending oriented. Most community banks are leveraging their assets to generate revenue in the form of interest income. Those interest generating assets span across different segments of loans including real estate loans, commercial and industrial loans and loans to individuals.
Interest income for banks is generally the largest single source of income. However, there are numerous types of loans that generate that income. Banks are striving for a granular portfolio of loans in an effort to reduce risk of loss. The different types of loans can vary from bank to bank, but often fall into a real estate, commercial and industrial and individual category. Each category is further managed based on other important aspects of the portfolio including the fixed rate vs. floating rate dynamic along with the duration (time to maturity) of the portfolio. Regardless, it's this mix of loans across a broad number of categories that generate interest income for the bank.
Banks also carry securities portfolios that generate income for the P&L. The securities portfolios are often made up of excess capital that banks are required to carry and banks are seeking to generate returns from this excess capital. Often these securities are low risk and risk free securities that generate market returns and generate income for the bank. Many banks build securities portfolios that consist of U.S. Treasuries and mortgage-backed securities.
The expense side of the equation that drives a banks net interest margin generally relates to what banks pay on interest bearing deposits. These interest bearing deposits come in many forms across the consumer and commercial spectrum and often consist of deposits with interest sensitive clients. Banks pay close attention to the deposit rates within both transactional and non-transactional accounts due to competitive pressures from the industry and the ease of moving money to another institution.
Interest expense paid on transactional and non-transactional accounts is often the largest component of the expense side of the P&L. This line item on the P&L is often the single most important factor that determines bank profitability. The bank is striving to keep this interest expense line item as low as possible while maintaining the deposit base on the balance sheet.
Non-interest expense is the other major component to the P&L of the bank and this is where the majority of the operating expenses hit the bank expense equation. The largest line item in non-interest expense is often related to labor in the form of salaries and benefits. Other expenses like the costs associated with physical assets including branches and corporate offices are significant contributors to non-interest expense.
As a fintech selling into a bank the more you know about the P&L the more effective you will be in selling to the bank. Further, the more insight you can gain in the sales process into forecasted P&L in the context of revenue growth, interest and non-expense forecasting and profitability forecasting, the better.
Especially to the extent a fintech is selling into the community bank space, roughly $1-10b in assets, a solid understanding of the inputs into Net Interest Margin is important. NIM is the key driver of profitability. For example, for a bank with a $1b loan portfolio, 1 basis point is worth $100,000 of revenue gained or lost. Those revenue numbers scale with asset size so one can see how important each basis point in NIM is to the overall revenue and profitability to the bank.
It is inevitable that NIM is going to change from period to period because there are factors that drive NIM that are beyond the control of the bank. For example, the macro interest rate market changes when the Federal Reserve manipulates the Fed Funds rate, which impacts the NIM of most every bank in the country. Understanding that NIM is going to change, keeping a base case and a downside case margin in operating expenses is important otherwise rapid cost cutting will have to take place to account for the drop in revenue.
There are takeaways that fintech's need to be aware of as it relates to the P&L of a bank. Understanding these takeaways will lead to more closed deals and a shorter sales cycle among other positive outcomes.
The more relevant the fintech is to the bank in the context of driving P&L outcomes, the shorter the sales cycle will be for the fintech. If the fintech, via the attributes of their product, can immediately pinpoint the impact to the P&L the buy-in from the bank C-suite will be much more rapid.
As discussed, many community banks are tied to one source of revenue associated with Net Interest Margin businesses. To the extent a fintech can help a bank develop complimentary sources of revenue (or even optimize the existing source of revenue), the outcomes for the bank and the fintech are generally positive.
Fortunately, much of the information a fintech needs to evaluate a bank P&L is publicly available even in the case of privately-held banks. Each quarter, and sometimes more often, a bank has to report to the FDIC via a "call report", financial information that the FDIC can use to evaluate the stability of the bank and the safety of insured deposits. A good start is to pull the call report to evaluate the P&L and develop talking points from a sales perspective.
As it relates to understanding the financials of a bank, the process of evaluating a bank does take time and will impact the time it takes to develop an approach to selling to a bank. Developing a repeatable process to evaluating a financials is key so you can develop a go-to-market process designed to highlight the key aspects of your product.
Banks and regulators operate primarily from peer comparisons as a proxy to understand and evaluate various aspects of a bank. Often banks, especially community banks in the $1-10b space have peer groups that are 100-500 banks deep and provide a great proxy for where that bank is against its peers. For example, a key peer comparison is profitability and if the bank is generating profitability that puts them in the top third of their peer group that bank is doing an exceptional job of managing its balance sheet (and other aspects of the business) to drive profitability.
The key to all of this understanding is finding ways to reduce the sales cycle in the context of a fintech selling to a bank. The more the fintech can understand about the current state of the financials along with the 12-24 month forecasts for the financials, the better and the shorter the sales cycle.
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Bank executive, fintech founder or business owner and want to get in touch regarding Finov8r advisory? Email me at allan@finov8r.com.
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