Bank of America's debt rating is weighing it down. Image source: iStock/Thinkstock.
Even though Bank of America (NYSE: BAC) has slashed $15 billion in annual expenses over the last five years, it's still not as profitable as Wells Fargo (NYSE: WFC). The problem, as I've discussed in a series of recent articles (see here,here, and here), is that Bank of America's revenue also lags its peers. And one reason it does is because its debt rating puts it at a disadvantage.
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Banks generate revenue in two ways: by earning interest income from their portfolios of loans and fixed-income securities and by collecting fee income from such things as overdraft charges, credit card interchange fees, and trading commissions. What we're concerned about here is the first type -- interest income, which is Bank of America's single largest source of revenue, accounting for a little less than half its top line.
A bank's net interest income is a function both of how much it earns on its portfolio of loans and securities as well as how much it pays to borrow the money that's used to buy the assets -- this is why it's called net interest income as opposed to just interest income. The objective is to maximize interest income and minimize interest expense.
*Adjusted for non-cash accounting charge. **The net interest margin shows how much a bank's asset portfolio yields, after interest expenses are deducted. Data source: Second-quarter financial filings.
While Bank of America struggles on both fronts, its high interest expense is particularly troubling, as a bank's ability to borrow money inexpensively is a competitive advantage. Consider this: Bank of America and Wells Fargo each borrowed roughly $1.3 trillion from depositors and institutional investors in the second quarter, but Wells Fargo paid $1 billion less to do so.
This means that Wells Fargo is not only more profitable than Bank of America, but also that Wells Fargo and others in a similar situation can compete more aggressively on the price of financial products and services, which should enable them to take market share away from banks with lower credit scores.
The reason that Wells Fargo can borrow money for less than Bank of America is because it has a higher debt rating. An "A" rating in the table below, which shows Moody's ratings of 10 major banks, is a middle-of-the-road investment grade rating with "low credit risk." A "Baa" rating, by contrast, while still investment grade, suggests "certain speculative characteristics."
Data source: Bank websites, Moody's.
Of course, none of this is a secret to Bank of America. "Our borrowing costs and ability to raise funds are directly impacted by our credit ratings," the bank says in its latest 10-K. "In addition, credit ratings may be important to customers or counterparties when we compete in certain markets and when we seek to engage in certain transactions."
This may seem like it would be easy to fix -- after all, when a person needs to improve their credit score, they just pay down debt and make sure they aren't late on future debt payments. Unfortunately for Bank of America, however, the issue with its rating is more fundamental. This is because the bank's trading units, which deploy a quarter of its assets, are one of the principal reasons the North Carolina-based bank has a lower debt rating than Wells Fargo, which has more modestly sized trading operations.
Moody's made this clear in its latest update on Bank of America's credit rating. The report singles out the bank's two credit challenges, the first of which is its "large capital markets franchise, which entails significant wholesale funding, opacity of risk taking, a more volatile earnings profile, and a confidence-sensitive customer base." The second is its "high historic earnings volatility."
The net result is that Bank of America's desire to provide a complete suite of universal banking products, trading in particular, is hindering its ability to compete on a level playing field in the commercial banking space -- which, it's worth pointing out, is Bank of America's bread-and-butter business.
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John Maxfield owns shares of Bank of America, U.S. 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.