Must-know: An overview of the Banking sector (Part 7 of 14)
Traditional banks’ challenges
Commercial or retail banks’ primary source of revenue is interest earned from loans. It all goes well if the borrower keeps paying the installments regularly. However, a problem occurs if the borrower isn’t able to repay the loan. When a borrower isn’t able to pay back the loan, the loan is considered a non-performing asset (or NPA). Since the money for lending came from a depositor, the bank needs a large enough pool of capital to withstand such a shock. This pool of capital is called a loan loss provision. When a bank makes a loan, it sets aside part of the value of the loan for such an event. A loan loss provision helps a bank tide over loans that become a NPA.
In normal situations, the loan loss provision is enough for a bank to tide over s NPA. However, when the economic situation deteriorates and there’s a slowdown or a depression, the loan loss provisions may not be enough to cover for a NPA and pay back depositors. In such a situation the bank has to pay back depositors from its common equity—generally shareholder capital and reserves accumulated from retained profits over the years. When a bank exhausts even this avenue it’s practically left with no money to pay back its depositors. During the Great Depression, many depositors lost their money. Today, deposits are partially insured by the Federal Deposit Insurance Corporation (or FDIC).
So, it’s clear that a bank needs to control its NPA levels to continue operating profitably for a long time. This can be done by prudent loan dispursals, stringent loan underwriting, and continuous follow up of borrowers. A bank also needs to price its loans correctly based on the risk-level of the borrower.
All traditional banks like Wells Fargo (WFC), U.S. Bancorp (USB), PNC Financial Services (PNC), Capital One (COF), or an exchange-traded fund (or ETF) containing mostly traditional banks like the iShares U.S. Regional Banks ETF (IAT) have to carefully navigate the a NPA to stay afloat.
Browse this series on Market Realist:
- Part 1 - Must-know: The Banking sector
- Part 2 - Must-know: The origins of banking
- Part 3 - Overview: Development of banking in the US
- Banking & Budgeting
- Financials Industry