Bank of America's trading and investment banking headquarters in New York City. Image source: Wikimedia Commons.
High expenses have long been the main reason that Bank of America 's(NYSE: BAC) profitability lags both its peers and commonly cited industry benchmarks. But after slashing costs for nearly a decade, the bank's biggest problem now is its revenue -- and its net interest income, in particular.
Bank of America earns about half its revenue each year from net interest income. That is, by borrowing money inexpensively from depositors and other wholesale lenders, and then using the funds to make loans and buy interest-earning securities.
The metric that captures this activity, known as interest rate arbitrage, is the net interest margin . This communicates how much a bank earns on its portfolio of interest-earning assets after interest expenses are subtracted. All else equal, a high net interest margin is better than a low one.
Let's say for example that Bank A earned $12 million in interest income last year and paid $2 million in interest expense. Its net interest income would be $10 million ($12 million minus $2 million). And if it had $400 million worth of interest-earning assets, then its net interest margin would be 2.5% ($10 million divided by $400 million).
The objective is to maximize the net interest margin, albeit without assuming too much risk. There are two keys to doing this. First, you have to be able to borrow money cheaply. And second, you have to generate a respectable yield on your earning assets.
Net Interest Margin (2Q16)
Bank of America
Adjusted for non-cash accounting charges. Data source: Quarter filings.
Bank of America has problems on both counts. But for present purposes, I will focus on the first one -- namely, why Bank of America's cost of funds is higher than that of one of its principal competitors, Wells Fargo (NYSE: WFC) .
In the second quarter, Bank of America paid $2.46 billion to borrow $1.3 trillion worth of funds. Meanwhile, Wells Fargo paid $1.41 billion to borrow $1.25 trillion worth of funds. This means that Bank of America paid $1 billion more than Wells Fargo to borrow essentially the same amount of money.
Let's start with what the answer is not. The answer isn't that Bank of America pays its depositors more than Wells Fargo does. The rate Wells Fargo paid on deposits was actually slightly higher last quarter, coming in at 0.15% compared to Bank of America's 0.13%.
And while most other sources of funds aren't significant enough to tip the scale in either direction, there is one exception: long-term debt. It's here where Bank of America is at a disadvantage relative to Wells Fargo. Even though these two banks have roughly the same amount of long-term debt on their balance sheets, Bank of America pays significantly more in interest.
Interest Rate on Long-Term Debt
Bank of America
All data from the second quarter of 2016. Data source: Quarterly filings.
If Bank of America paid the same rate on its long-term debt as Wells Fargo does, then its net interest income would increase by more than $400 million a quarter. That's a lot of money when you consider that Bank of America tends to earn only $4 billion a quarter in total income.
So, why will wholesale lenders loan money to Wells Fargo at a lower rate than they'll lend it to Bank of America?
The answer is that Wells Fargo has a better debt rating -- which, as is the case for people with higher credit scores, translates into lower borrowing costs. Moody's, one of three main rating agencies, gives Wells Fargo's long-term debt a rating of A2, a middle-of-the-road investment-grade rating. Bank of America's long-term debt rating, by contrast, is Baa1. That's still investment grade on Moody's rating scale, but it's closer to the bottom of what qualifies.
In sum, if you're trying to dig deep into Bank of America's profitability problems, then one thing you need to get your head around are the reasons that the North Carolina-based bank's debt rating is lower than that of peers such as Wells Fargo.
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John Maxfield owns shares of Bank of America 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 .