Explaining the Role That Leverage Plays in Bank of America's Low Profitability

Analyzing a company is like peeling an onion, there are multiple layers. Image source: StockByte/Thinkstock.

It's no secret that Bank of America's (BAC 2.99%) profitability lags behind that of JPMorgan Chase (JPM 2.04%) and Wells Fargo (WFC 2.35%), but I suspect the precise explanation for its subpar performance is more mysterious.

With this in mind, I sharpened my pencil and revved up my calculator to figure out why Bank of America's return on average common equity -- the quintessential profitability metric for banks -- was only 6.2% last year compared to JPMorgan's 10.5% and Wells Fargo's 12.8%.

If you analogize this process to an onion, the first layer has to do with leverage.

Source: Fourth-quarter earnings releases and supplements.

Banks make money by borrowing funds at low interest rates from people and businesses with a surplus of money and then lending it back out at higher rates to people and businesses with a deficit. The difference between a bank's cost of funds and the interest it receives on its earning assets is its net interest income, which feeds directly into revenue.

It should be clear if you follow this logic that the extent to which a bank can borrow money plays a major role in how much it earns. Let's say that Bank ABC has $10 million in capital (i.e., equity) and accepts $100 million in deposits. This means it's leveraged by a multiple of 10. If Bank ABC then earns 1% on its assets each year, which is a standard industry benchmark, then its net income will be $1 million. This equates to a 10% return on equity -- another standard industry benchmark.

But now let's assume its neighbor, Bank XYZ, leverages its equity by a multiple of 5, or half as much as Bank ABC. Assuming that Bank XYZ also borrows $100 million and earns the same 1% return on assets, then its return on equity would be only 5% ($1 million divided by $20 million in equity), or half as much as Bank ABC's.

With all else equal, then, a bank that uses more leverage will earn more money than a bank that uses less. Herein lies the first layer of the onion that explains why Bank of America isn't as profitable as JPMorgan Chase or Wells Fargo. As you can see in the table below, Bank of America leverages its common equity by a multiple of 9.3 compared to multiples of 11.2 and 10.4 at JPMorgan Chase and Wells Fargo.

Source: Fourth-quarter earnings releases and supplements.

Sparing you the cumbersome math, if Bank of America was leveraged to the same extent as JPMorgan Chase, it would earn $4.2 billion more a year, holding all else equal. And if Bank of America was leveraged to the same degree as Wells Fargo, it would earn $3.1 billion more a year.

So, why isn't Bank of America more leveraged? In a nutshell, the Federal Reserve requires it to retain a larger share of its earnings each year than either JPMorgan Chase or Wells Fargo. This boosts Bank of America's retained earnings, which is a component of common equity -- the denominator in the return-on-equity calculation. The reason the Fed requires it to retain so much more than its peers stems from Bank of America's transgressions over the past decade. The regulators simply don't trust it as much as they do JPMorgan Chase or Wells Fargo.

Thus, to return to our onion analogy, if leverage is the outermost layer of flesh, then trust is the crispy skin that surrounds it.