Bank of America (NYSE:BAC) is one of the least profitable big banks in the United States when measured by return on equity, the industry's leading profitability metric. Even excluding its astronomical legal bills from the past few years, its business model still suffers from at least three systemic weaknesses.
1. Low leverage
At their core, banks are nothing more than highly leveraged investment funds. They take a small amount of capital, leverage it up with a large amount of inexpensive debt -- principally deposits -- and then invest the borrowed proceeds into a variety of interest-earning assets, including loans and fixed-income securities.
Done right, this can be incredibly lucrative. By leveraging their assets by a factor of 10 to one, good banks can transform a 1.5% return on assets into a 15% return on equity. It's for this reason that a bank's profitability is directly related to the extent of its leverage.
With this in mind, it should come as no surprise that Bank of America is less leveraged than its too-big-to-fail peers. When you look only at its common equity, the Charlotte, N.C.-based bank is leveraged by a factor of 9.4 to one. Meanwhile, its much more profitable peers, such as JPMorgan Chase, Wells Fargo, and U.S. Bancorp, are all leveraged by factors of 10 to one or more.
2. Unproductive assets
Although banks leverage their capital by buying assets, not all assets are created equal. Some assets, known as interest-earning assets, generate revenue, while others lie fallow on a bank's balance sheet and produce little to no value for shareholders.
Goodwill is a textbook example of the latter type of asset. This is an intangible asset that materializes when one bank buys another bank for more than the fair-market value of the latter's assets. The main purpose of goodwill is to reconcile the premium paid on the acquiring company's balance sheet.
The downside to an asset like goodwill and other non-interest-earning assets is that they crowd out more profitable holdings. Take U.S. Bancorp, one of the best-run lenders in the country, as an example: Only 10% of its assets don't earn interest. Meanwhile, the same figure for Bank of America is 16%. That 6% difference translates into $125 billion worth of assets when you consider that Bank of America's total asset portfolio adds up to $2.14 trillion. So multiply $125 billion by Bank of America's 2.73% yield on earning assets, and you're talking about $3.4 billion in foregone interest income annually.
3. Net interest margin
On a related note, not only does a comparatively small percentage of Bank of America's total assets earn income, but the assets that do generate interest do so at a lower rate than most other banks' assets. You can see this by looking at Bank of America's net interest margin, which is the percent of net interest income a bank earns on its interest-earning assets.
In the latest quarter, Bank of America's net interest margin was 2.17%. The same figure for Wells Fargo was 2.95%, and the average of the 10 biggest traditional lenders was 3.21%.
The reason Bank of America struggles in this regard is because its universal business model -- by "universal" I mean that it operates as both an investment bank and a traditional lender -- requires it to stay much more liquid, for regulatory reasons, than banks that focus on taking deposits and underwriting loans. Currently, only 41% of Bank of America's assets consist of loans compared to an average of 64% among other leading lenders.
The bottom line on Bank of America
When you consider these three systemic weaknesses, it should be clearer why Bank of America struggles to generate the same degree of profitability as its better-heeled peers. However, it should also be clear that, assuming the nation's second-biggest bank can get its operations in order, there is a large opportunity for it to improve and thereby reward loyal shareholders who stuck with it through thick and thin over the past decade.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, JPMorgan Chase, 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.