Wells Fargo (NYSE:WFC) is perceived to be a safer bank than both Bank of America (NYSE:BAC) and Citigroup (NYSE:C). But the impact this has on the bottom line of Wells Fargo compared to the other two is drastic.
The stunning lead
Taking a step backwards, it's important to know at their core, banks are intermediary institutions which borrow significant amounts of money -- principally in the form of deposits -- and in turn lend that money out to individuals and companies. The dollar difference between what they pay out on deposits and other sources of funding versus what they earn on mortgages and other loans is known as net interest income, and the rate difference is known as net interest margin.
While it's not sexy and won't grab headline attention, both of these are critical numbers to keep an eye on for the banks. And as shown in the table below, you can see just how vital these numbers are:
As you can see, Wells Fargo holds a resounding lead when it comes to net interest margin. Although we're talking about seemingly small differences -- Citigroup trailing by 0.3% -- it has a monumental impact on the trillions of dollars at banks.
For example, if Bank of America had a net interest margin of 3.2% on its $1.8 trillion in assets, it would've increased its net interest income by a staggering $4.1 billion in the first quarter. And while Citigroup its closer to Wells Fargo, adding an additional 0.3% to its net interest margin would've resulted in $1.3 billion more going to its bottom line.
So the natural question becomes, despite its smaller asset base, how is Wells Fargo able to beat Bank of America and Citigroup so spectacularly?
It's not what it earns, but what it pays out
Banks can do only do a few things to boost their net interest margin. They can either increase the rate they earn on their assets, or they can attempt to reduce the rate they pay out on their liabilities.
Reaching for higher yields on their interest earning assets can have disastrous consequences, and such actions are one of the things which led to the great recession. And in such a competitive environment, charging higher rates to existing customers would lead to the severing of countless relationships.
But at the same time, what they pay out on liabilities is more controllable. After all, the higher the perceived safety of a company, the lower the rate those lending to it will demand. And it is here where Wells Fargo comes out on top:
As shown in the chart, it isn't as though Wells Fargo takes a commanding lead on the rate it earns on its assets, but instead the rate it's required to pay out on what it borrows.
Why this matters
It isn't simply those who own the common stock who perceive it as being safer -- this is why it trades at a distinctly higher premium (2.2 times price to tangible book value) than both Bank of America (1.2) and Citigroup (0.9) -- but it's creditors.
There should be two major takeaways. The first is Wells Fargo is indeed perceived to be safer by those whom it matters most.
The second is while Bank of America and Citigroup trail Wells Fargo by a wide margin and pay a premium to those holding their debt, it should serve as a focus area for the banks.
They should seek to reduce their funding costs as they further distance themselves from the troubles which marked them during financial crisis. Cutting their cost of funding in half -- they would still be trailing Wells Fargo -- would have major boosts to their bottom lines.
What banks earn on their assets versus what they pay out on their liabilities don't grab headlines, but are critical for investors, as major changes can result in huge changes to their income.
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Patrick Morris owns shares of Bank of America. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.