An Important Question for Bank of America Investors

By Markets Fool.com


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The question that should haunt every Bank of America (NYSE: BAC) investor is this: Why is the North Carolina-based bank so much less profitable than its peers Wells Fargo (NYSE: WFC) and U.S. Bancorp (NYSE: USB)?

Bank

Return on Equity (TTM)

U.S. Bancorp

14.4%

Wells Fargo

13%

Bank of America

6.2%

Data source: YCharts.com.

The answer to this question for much of the past eight years was that Bank of America's expenses were too high. After all, the nation's second biggest bank by assets has incurred more than $200 billion in litigation and other added costs since the financial crisis.

But these costs have now largely been addressed. The lion's share of Bank of America's legal liabilities are in the rearview mirror. It's cleaned up its balance sheet, charging off or otherwise disposing of copious amounts of delinquent mortgages and credit card loans. And it's cut tens of thousands of employees and closed one out of five of its pre-crisis branches.

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Bank of America's operating expenses are even lower now than the notoriously efficient Wells Fargo and U.S. Bancorp's if you adjust for the banks' respective sizes.

Bank

Noninterest Expenses as a Percent of Average Assets (2Q16)

U.S. Bancorp

2.79%

Wells Fargo

2.76%

Bank of America

2.47%

Data source: Quarterly financial filings.

Given this, if you're trying to figure out why Bank of America is so much less profitable than Wells Fargo and U.S. Bancorp, then you need to look somewhere other than expenses.This leaves revenue as the culprit. And if you dig into Bank of America's financial statements, it's clear that the bank is especially challenged when it comes to net interest income.

The main way most banks generate income is to borrow funds at super-low interest rates from depositors and then to lend that money out at higher rates to people and businesses who need loans. In Bank of America's case, 45% of its net revenue comes from net interest income. Its next largest source is asset management and brokerage fees, which accounted for 16% of the bank's top line in the second quarter.

The key to maximizing net interest income is the spread between what it costs to borrow money from depositors (interest expense) and what a bank can earn by lending that money out (interest income). The bigger the spread, the bigger the net interest income. This iscaptured by the net interest margin, which conveys how much a bank earns from its loan and securities portfolios after subtracting the cost of funds.

Figures from Wells Fargo's latest earnings report show how this works. The California-based bank reported $13.4 billion worth of interest income and $1.4 billion worth of interest expense in the most recent quarter, leaving it with net interest income of $12 billion. If you annualize that -- i.e., multiply it by four -- you get $48 billion. If you then divide that by the average of Wells Fargo's earning assets over the quarter, you get 2.86% -- its net interest margin.

It's here, then, where you can get a sense for Bank of America's revenue troubles. After adjusting for accounting irregularities, Bank of America's net interest margin in the second quarter was 2.24%, which is meaningfully less than at Wells Fargo and U.S. Bancorp.

Bank

Net interest Margin (2Q16)

U.S. Bancorp

3.02%

Wells Fargo

2.86%

Bank of America

2.24%*

*Adjusted for non-cash accounting charges.Data source: Quarterly financial filings.

I know it may seem like I'm splitting hairs here. After all, Bank of America's net interest margin is only 0.62 percentage points less than Wells Fargo's. How big of a difference could this make?

The answer is: very big.

While the percentage may be small, the quantity of earning assets at these banks is massive. Bank of America holds $1.9 trillion worth of earning assets. If it were to earn 0.62% more on this portfolio, it would equate to $11.6 billion worth of additional annual pre-tax income.

That's a big chunk of change when you consider that Bank of America's total net income applicable to common stockholders last year was only $14.4 billion.

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John Maxfield owns shares of Bank of America, US Bancorp, and Wells Fargo. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool recommends Bank of America. 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.