Before you invest in any company, you should fully understand how its business works. Banks have an odd model for the uninitiated, so let's take a few minutes today to break down exactly how one bank earns its keep via a case study.
Enter M&T Bank
M&T Bank Corporation (NYSE:MTB) is a regional commercial bank in the Mid-Atlantic region of the U.S. M&T isn't an overly complex Wall Street-styled bank, which will make this breakdown that much easier -- and will also make your investment analysis that much simpler.
M&T's primary business is accepting deposits and making loans. The bank pays a small interest rate to depositors, and then uses those deposits to originate loans at a higher interest rate. The difference, or "spread," is called the bank's net interest margin, and constitutes the primary function of the bank.
That core is supplemented with non-lending services that generate what's called "non-interest income."
Breaking down M&T's lending business
To break down M&T's businesses with as much granularity as we can, we'll use data available through the bank's quarterly regulatory filing with the FDIC called its "call report," and supplement that with annual data provided by S&P Capital IQ.
M&T currently reports a net interest margin of 3.32% for Q3 of 2014, which is strong relative to the average of all U.S. banks with more than $10 billion in total assets. According to the FDIC's Quarterly Banking Profile, those large institutions averaged a net interest margin of 3% for the same period.
That margin translates to $682 million in net interest income for the third quarter. Total interest income was $743 million netted against total interest expense at $61 million.
That outperformance was driven by a lower cost of funding than the industry average, meaning that the bank's deposit base and any other borrowings are less costly than at other institutions. The bank's loan yields are comparable to the rest of the industry.
The loan portfolio consists primarily of commercial loans to businesses and commercial mortgages. The bank also has a sizable consumer loan business, mortgage lending business, and some exposure to construction projects.
From this breakdown, we can draw several conclusions. First, about half (48%) of the bank's loans are backed by real estate. Excluding the obvious exception of the financial crisis, real estate loans have historically been a strong business for banks. As long as the bank maintains a strong credit culture with appropriate loan-to-value ratios on those loans, real estate is among the most secure collateral types.
The bank seems to have an appropriate balance between retail and business banking, with no obvious concentration issues to speak of. So far, so good.
Breaking down M&T's non-interest income
In addition to the lending business, M&T also brings in a considerable amount of income from non-lending activities. Total non-interest income was $433 million for the third quarter. That's 39% of the bank's income.
There are two primary drivers of the bank's non-interest income. The first driver is fees related to the various deposit accounts the bank offers. This would include overdraft fees, service charges, and transactional fees. Second is income from the bank's trust and estate business.
For banks with traditional banking models, having a robust ancillary business like a trust company is a major benefit. These businesses smooth out profits throughout the credit cycle, and add an attractive bit of diversity to the bank's income stream. At the same time, they do not bring too much risk to the bank like you may see with more complex banks on Wall Street or elsewhere.
The bank also nets a healthy bit of cash flow from fees related to its residential mortgage business.
M&T Bank runs a very traditional bank business model. The primary driver of the bank's revenue is in accepting deposits and originating loans. The bank has a diversified loan portfolio between both commercial and consumer loan types, and it has a very healthy net interest margin driven by a well-structured deposit base.
Better yet, the bank has a strong income stream from non-lending businesses, headlined by the bank's trust division. M&T has also demonstrated that it is adept at maximizing revenues by appropriately charging fees for deposit, cash management, and mortgage services.
Banking can be a pretty complicated business. Fortunately for investors in M&T Bank, though, this bank keeps it pretty simple.