How Commercial Banks Make Money: The Spread Business

Introduction

The commercial banking business model is deceptively simple: accept deposits from savers, lend money to borrowers, and earn the difference between the interest charged on loans and the interest paid on deposits. This "spread" is the foundation of banking and has been for centuries. But beneath this simplicity lies enormous complexity in how banks source funding, deploy capital, manage risk, and generate returns for shareholders. Understanding the commercial banking revenue model is the starting point for all FIG analysis, whether you are valuing a bank, modeling an acquisition, or preparing for an interview.

The US banking industry comprises approximately 4,487 FDIC-insured institutions with combined assets exceeding $24 trillion, generating aggregate net income of $268 billion in 2024. From JPMorgan Chase (with $4.1 trillion in assets) to single-branch community banks with $50 million in assets, they all operate some version of the same fundamental model: gather deposits, make loans, earn the spread, and manage the risks in between.

Globally, the banking industry is far larger. The world's 1,000 biggest banks held approximately $164 trillion in total assets and generated a record $5.5 trillion in revenue in 2024, with aggregate net income of approximately $1.2 trillion. The four largest banks by assets are all Chinese (ICBC alone holds nearly $6.7 trillion), while the largest European banks (HSBC at $2.9 trillion, BNP Paribas at $2.9 trillion) rival the largest US institutions in scale. For FIG bankers at bulge bracket firms, cross-border mandates involving European and Asian banks are increasingly common, and understanding how the same spread business model operates under different rate environments, regulatory regimes, and deposit market structures is essential for global coverage.

Net interest income (NII) is the dominant revenue source for most commercial banks, typically representing 60-75% of total revenue. NII is the difference between interest earned on assets (loans, investment securities) and interest paid on liabilities (deposits, borrowings).

The key metric for analyzing NII is the net interest margin (NIM): NII as a percentage of average earning assets. For the US banking industry, the full-year 2024 NIM was 3.22%, meaning banks earned approximately $3.22 for every $100 of earning assets deployed. For established US regional banks, a healthy NIM typically falls between 2.5% and 3.5%.

The NIM landscape differs substantially outside the US. European banks operated with a NIM of approximately 1.58% in Q3 2024, declining to 1.50% by Q3 2025 as the ECB cut rates through the second half of 2024. This structural NIM gap (US banks earning roughly double the spread of European peers) reflects several factors: lower benchmark rates in Europe, more competitive deposit pricing in fragmented European markets, and the prevalence of variable-rate mortgages in some European jurisdictions that compress asset yields when central banks cut rates. Despite narrower NIMs, European banks achieved a return on equity of approximately 10.5% in 2024, partly by maintaining higher leverage ratios and partly through stronger fee income growth. The NIM gap is a critical consideration in cross-border bank comparisons and cross-border M&A analysis.

What Drives Interest Income

The asset side of the bank generates interest income from three primary sources:

Loans are the largest earning asset category and the highest-yielding. The loan portfolio typically represents 60-70% of earning assets and generates yields of 5-8% depending on the rate environment and loan mix. Commercial and industrial (C&I) loans, commercial real estate (CRE) loans, residential mortgages, and consumer loans each carry different yields and risk profiles.

Investment securities (government bonds, agency mortgage-backed securities, municipal bonds) represent 20-30% of earning assets. These are lower-yielding than loans (typically 2-5%) but serve critical functions: liquidity management, interest rate hedging, and pledging requirements for public deposits. The classification of these securities as HTM or AFS has important accounting and capital implications.

Other earning assets include fed funds sold, reverse repos, and balances at the Federal Reserve, typically earning short-term market rates.

Earning Assets

The assets on a bank's balance sheet that generate interest or investment income. Earning assets include loans (the largest and highest-yielding category), investment securities (bonds and mortgage-backed securities held for liquidity and hedging), and short-term investments (fed funds sold, balances at the Fed). Earning assets typically represent 85-90% of a bank's total assets, with the remainder being non-earning assets like cash, premises, and goodwill. The composition and yield of earning assets are the primary determinants of a bank's interest income and NIM.

What Drives Interest Expense

The liability side determines the bank's cost of funding:

Deposits are the primary funding source and the cheapest. Non-interest-bearing deposits (checking accounts) cost zero in explicit interest. Interest-bearing deposits (savings accounts, money market accounts, CDs) carry varying costs depending on the rate environment and competitive dynamics. The weighted average cost of deposits is the single most important funding metric. Banks with large, stable, low-cost deposit franchises have a structural competitive advantage because they can fund loans more cheaply than competitors relying on higher-cost funding.

Wholesale borrowings (Federal Home Loan Bank advances, fed funds purchased, repurchase agreements, subordinated debt) are used to supplement deposit funding, particularly during periods of loan growth that outpace deposit growth. Wholesale funding is more expensive and less stable than core deposits.

The speed at which deposit costs respond to changes in the fed funds rate is measured by deposit beta: the percentage of a rate increase that is passed through to depositors. A bank with a 40% deposit beta passes $0.40 of every $1.00 rate increase through to depositors, retaining $0.60 in expanded NIM. Deposit betas vary by account type (CDs reprice fastest, non-interest-bearing checking reprices not at all) and by competitive environment (banks with dominant local market share can maintain lower betas). During the 2022-2024 hiking cycle, cumulative deposit betas across the US industry reached approximately 45-55%, though individual banks ranged from under 30% (strong deposit franchises with sticky relationships) to over 60% (rate-sensitive digital and brokered deposit bases). Deposit beta analysis is a core component of FIG earnings projections and M&A due diligence.

Non-interest income (fee income) is the second major revenue source, typically representing 25-40% of total revenue for commercial banks and an even higher share for universal banks with capital markets operations.

Fee income comes from several categories:

Service charges and fees: Account maintenance fees, overdraft fees (declining post-regulation), ATM fees, and wire transfer charges. These are declining as a revenue source due to regulatory pressure and competitive dynamics.

Treasury and cash management: Corporate clients pay for payment processing, lockbox services, liquidity management, foreign exchange, and trade finance. This is a growing and highly sticky revenue source because switching costs are high once a company integrates its treasury operations with a bank's platform.

Wealth management and trust fees: Asset-based fees on client assets under management, financial planning fees, and trust administration fees. Banks with strong wealth management franchises (like US Bancorp or JPMorgan's Private Bank) generate significant recurring fee income that is less interest-rate-sensitive than NII.

Mortgage banking: Origination fees and gains on sale of mortgages into the secondary market. This revenue is highly cyclical: it surges during refinancing waves (when rates drop) and collapses when rates rise.

Capital markets and trading revenue: For universal banks (JPMorgan, Bank of America, Goldman Sachs, Morgan Stanley), trading revenue from fixed income, currencies, commodities (FICC), and equities can represent a substantial share of total revenue. JPMorgan's trading and investment banking revenue combined exceeded $50 billion in 2024.

Revenue tells only half the story. Two major cost categories determine how much of that revenue reaches shareholders:

Operating Expenses and the Efficiency Ratio

The efficiency ratio measures operating expenses (compensation, technology, occupancy, marketing, regulatory compliance) as a percentage of total revenue. A lower efficiency ratio means the bank converts more revenue into profit. The industry median is approximately 55-65%. Best-in-class operators like JPMorgan and US Bancorp target efficiency ratios in the low 50s; banks undergoing investment cycles or facing revenue pressure may see ratios in the high 60s or above.

The efficiency ratio is the primary operational lever that bank management can control (unlike NIM, which is heavily influenced by the rate environment and competitive dynamics). This is why cost synergies (reducing the combined entity's efficiency ratio) are the most tangible value driver in bank M&A.

Provision for Credit Losses

The provision for credit losses represents the expected cost of loan defaults. It is the most volatile expense line on the bank income statement because it is driven by macroeconomic conditions rather than management decisions. During benign credit environments, provisions may represent 5-10% of revenue. During recessions, provisions can consume 30-50% of revenue, as banks reserve for anticipated defaults.

The provision flows through to the allowance for credit losses (ACL) on the balance sheet, which represents the bank's cumulative reserve against potential loan losses. Under CECL (Current Expected Credit Losses), banks must reserve for expected lifetime losses at loan origination, introducing forward-looking macroeconomic assumptions into the reserve calculation. The net charge-off (NCO) rate (actual losses divided by average loans) is the most important credit quality metric because it captures realized losses rather than management estimates. The US industry average NCO rate in 2024 was approximately 0.65%, though this masks wide dispersion: credit card portfolios can experience NCO rates of 4-6%, while commercial real estate typically runs under 0.3% in normal environments.

The full income statement waterfall for a commercial bank follows this structure:

These proportions shift depending on the bank's size, business mix, and the rate environment. A community bank with a strong local deposit franchise might generate 80% of revenue from NII with minimal fee income, while a universal bank like JPMorgan generates closer to 50/50 between NII and non-interest income. In a rising rate environment, NII typically expands (assuming deposit betas lag rate increases), lifting PPNR margins. In a falling rate environment, NII compresses, and banks with greater fee income diversification outperform.

In non-financial companies, debt is a financing choice: how much leverage to employ in the capital structure. In banking, debt is the raw material of the business itself. Deposits (which are a form of debt owed to depositors) are the input that banks transform into loans, earning a spread in the process. This is why traditional valuation metrics like EV/EBITDA do not work for banks: you cannot subtract debt from a bank's value because debt (deposits) is the business.

This fundamental distinction is what makes FIG a specialized coverage group. The metrics (NIM, efficiency ratio, ROTCE, P/TBV), the risks (credit quality, interest rate sensitivity, regulatory capital requirements), and the deal structures (deposit premiums, TBV dilution earn-back) are all unique to financial institutions. The model is the same whether you are analyzing JPMorgan in New York, HSBC in London, or ICBC in Beijing. The spread business is universal; only the spreads, regulatory frameworks, and competitive dynamics differ.

The remaining articles in this section examine each element of the commercial banking model in detail: the deposit franchise that determines funding costs, the loan portfolio that generates yields, the interest rate risk management that protects the spread, and the business lines and structural features that shape how different types of banks compete within the same fundamental model.