Please ensure Javascript is enabled for purposes of website accessibility

What Is a Commercial Bank, and How Does It Make Money?

By Motley Fool Staff - Updated Feb 13, 2018 at 3:03PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Here's a look at how commercial banks operate and where their revenue comes from.

In this Industry Focus: Financials clip, host Michael Douglass and banking specialist Matt Frankel take a closer look at commercial banks, discussing heavyweights Wells Fargo (WFC 1.92%) and U.S. Bancorp (USB 1.24%). Watch the video below to learn what a commercial bank is, and how these institutions make their money.

A full transcript follows the video.

This video was recorded on Feb. 2, 2018.

Michael Douglass: What is a commercial bank, and how was it different from, say, a universal bank or an investment bank?

Matt Frankel: A commercial bank is one that looks like what you normally think of as a bank. A bank's primary business focus is to take in deposits from customers and make loans to other customers and profit from the spread in between those. Commercial banks also engage in some other activities, such as wealth management. Some have insurance operations like, they'll partner with an insurance company and sell it to their customers, safe deposit boxes, credit card businesses, things of that nature. But, in general, they avoid investment banking activities such as M&A advising, trading, underwriting, things like that. They're more of what you would consider a traditional savings and loan bank.

Douglass: Exactly. I think that's a critical thing. When you think about banking, probably, and if you haven't seen The Big Short, you're probably thinking about banks a lot like U.S. Bank and Wells Fargo. Let's start with part one of the framework, which is, how do the banks make money, and what do they actually do?

Frankel: Both Wells Fargo and U.S. Bank have, like I said, one basic activity, which is to loan money and take deposits. That split between what's known as community banking, which is, when you open a checking account, you're part of the community banking system, which refers to banking products and services that they sell to individual customers -- loans, deposit accounts, credit cards. There's also wholesale banking, which is the business banking line of it, business checking accounts, governmental banking products. And both of these are also engaged in wealth management businesses. Commercial banks don't quite put the emphasis on wealth management that the investment banks or the universal banks tend to, but it's still a big part of their business. Wells Fargo Advisors is a pretty big division, it brought in over $4 billion in revenue last quarter. So, these banks do have substantial wealth management businesses in addition to what you would normally think of as a community bank.

Douglass: And you can see this by looking at their balance sheet. Assets, Wells Fargo, about $1.94 trillion. U.S. Bank, $462 billion. Loans make up about half of Wells Fargo's assets, and closer to two-thirds of U.S. Bancorp's. Most of the rest is securities, which is tied up in all of the wealth management activity. One other thing that's important to note is assets vs. deposits. Wells Fargo, again, about $1.94 trillion in assets, about $1.3 trillion in deposits. U.S. Bank, it's $462 billion and $347 billion. So, in both cases, most of their assets are covered by deposits, and they actually have deposit exceeding their loans. That means they're still taking on some debt, but they are a lot more heavily covered than you tend to see on, for example, the investment banking side.

Frankel: Right. Investment banking, you'll see, they have a lot more securities on their balance sheet generally, in their trading divisions. Neither Wells Fargo nor U.S. Bank has a significant trading desk. That's why you see the mix shift toward mostly deposits, definitely well over half in both cases. And loans being well-covered by those deposits. They're not financing their loans with debt. Like I said, the traditional business of taking in money and trying to loan all that money out.

Douglass: Right. The other thing that really highlights that is when you look at their income statement, you look at the metrics of net interest income and non-interest income. Net interest income is, again, that money that they're making from those loans. And non-interest income is everything else. In both cases, net interest income makes up a clear majority of their total net revenue. That's, again, a sign that these are both fairly traditional banks.

Frankel: Yeah. Non-interest income includes things such as all the fees they're getting from those wealth management businesses. I mentioned that Wells Fargo's in particular is pretty big. Also, this includes things like safe deposit box rental, every time you get an overdraft fee on your bank account, the monthly checking account fees, which has become very prevalent in the banking industry, unfortunately, over the past few years. I remember, my checking account used to be free. I don't know about Michael's. These are the things that are in the non-interest income category. So, it may seem like a lot that Wells Fargo, although it's pretty much a traditional savings and loan, is generating almost $10 billion a quarter in non-interest income. It's actually pretty standard when you think of all the fees that banks charge for their services.

Douglass: Which you can think of as ancillary to those traditional banking activities. Again, an overdraft fee doesn't tell us that it's not a traditional savings and loans bank. So, yeah, part of the drawback of looking at any metric is you really have to understand the nuance. So, that's a good point to throw in there.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Wells Fargo & Company Stock Quote
Wells Fargo & Company
$39.92 (1.92%) $0.75
U.S. Bancorp Stock Quote
U.S. Bancorp
$46.59 (1.24%) $0.57

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 07/03/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.