This lesson explains the fundamental business model of a commercial bank and introduces the core financial statements used to evaluate its performance and financial health.

6.1 The Core Banking Business Model
A commercial bank’s primary business model is financial intermediation—channeling funds from savers (depositors) to borrowers (individuals and businesses). The bank generates profit by earning a higher return on its assets (primarily loans) than it pays on its liabilities (primarily deposits).

• Net Interest Income (NII): The difference between interest earned on assets and interest paid on liabilities.

• Net Interest Margin (NIM): NII expressed as a percentage of average earning assets. This is a key profitability metric.

• Non-Interest Income: Fees and commissions from services such as account maintenance, advisory, trade finance, and wealth management.
  Banks are funded by a mix of customer deposits, wholesale funding (interbank borrowing), and capital (shareholders’ equity).

6.2 Understanding the Bank Balance Sheet
A bank’s balance sheet provides a snapshot of its financial position at a point in time.

• Assets (Uses of Funds):

  • Loans and Advances: The largest asset category, including mortgages, commercial loans, and consumer credit.

  • Investment Securities: Government bonds and other securities held for liquidity and income.

  • Cash and Due from Banks: Reserves held at the central bank and balances with other banks.

• Liabilities (Sources of Funds):

  • Deposits: The primary funding source, including demand, savings, and time deposits.

  • Borrowings: Funds borrowed from other banks or through issuing debt securities.

• Capital: The owners’ stake in the bank, acting as a buffer against losses.

6.3 Understanding the Bank Income Statement (P&L)
The income statement shows the bank’s financial performance over a period.

• Interest Income: Revenue from loans and securities.

• Interest Expense: Costs of deposits and borrowings.

• Net Interest Income (NII): The difference, a key driver of profitability.

• Non-Interest Income: Fee-based revenue (e.g., from advisory, trade finance, and service charges).

• Non-Interest Expense: Operating costs, including salaries, technology, and overheads.

• Provisions for Loan Losses: Funds set aside to cover expected loan defaults (a key cost).

• Net Income: The bottom line, or profit after all expenses and taxes.

6.4 Key Performance Metrics
Bank performance is evaluated using several key metrics:

• Return on Equity (ROE): Net income divided by shareholders’ equity—measures profitability relative to capital.

• Return on Assets (ROA): Net income divided by total assets—measures overall efficiency.

• Efficiency Ratio: Non-interest expenses divided by revenue—a measure of operational efficiency.

• Net Interest Margin (NIM): NII divided by average earning assets.

• Capital Adequacy Ratio: A measure of the bank’s financial strength (discussed in Lesson 5).

6.5 The Asset-Liability Management (ALM) Committee (ALCO)
A key governance body in a bank is the Asset-Liability Management Committee (ALCO). ALCO is responsible for managing the bank’s interest rate risk, liquidity risk, and overall balance sheet strategy. It ensures that assets and liabilities are managed in a coordinated manner to optimize profitability while maintaining safety.