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CFA Level II Exam · Analysis of Financial Institutions

Business Models of Banks and Financial Institutions

Updated 7 October 2026 · Fact-checked

A bank earns money mainly from net interest income: interest on loans and securities minus interest paid on deposits and borrowings. It also earns fees and trading income. To solve exam questions, find the income source in the vignette, compute the margin or ratio, and judge risk from funding, capital and asset quality.

Understand Business Models of Banks and Financial Institutions

A bank is a leveraged intermediary. It takes deposits and other funding, then lends or invests the money at higher rates. The difference between what it earns and what it pays is its spread. This is why banks hold mostly financial assets and carry far more debt-like liabilities than a normal company.

A bank's income has two broad parts. Net interest income (NII) is interest income minus interest expense. Non-interest income includes fees and commissions, trading gains, wealth management and advisory income. A bank with a high share of fee income depends less on interest rate moves but can be more tied to market activity.

The balance sheet is not split into current and non-current items. Banks usually present assets and liabilities in order of liquidity. Assets are mainly cash, central bank balances, securities and loans (shown net of the allowance for loan losses). Liabilities are mainly customer deposits, wholesale funding and debt. Equity is thin compared with total assets, so small asset losses can hit equity hard.

This changes how you analyze them. Ratios like the current ratio or inventory turnover have little meaning. You focus on margins, funding stability, liquidity, capital adequacy and asset quality. Higher loan growth can look good but can signal weak underwriting, so read it with provisions and non-performing loans.

Other financial institutions differ. Insurers earn underwriting profit plus investment income on premiums held before claims are paid. Asset managers earn fees linked to assets under management. Broker-dealers earn commissions, trading and financing income. In all cases ask: what is the revenue driver, how is it funded, and what risk is taken?

Key formulas to remember

Net interest income
NII = Interest income − Interest expense
Core earnings measure for a bank. Check the vignette for the exact labels.
Net interest margin
NIM = NII ÷ Average interest-earning assets
Use average earning assets, not total assets, if earning assets are given.
Interest spread
Spread = Yield on earning assets − Cost of interest-bearing liabilities
Differs from NIM because NIM also reflects funding from non-interest-bearing sources such as equity.
Loan-to-deposit ratio
Loans ÷ Deposits
A high value suggests reliance on wholesale funding and tighter liquidity.
Efficiency ratio
Non-interest expense ÷ (NII + Non-interest income)
Lower is better. It measures cost per unit of revenue.
Equity multiplier (leverage)
Total assets ÷ Total equity
Banks have high values, so ROE is very sensitive to asset returns.
Return on assets
ROA = Net income ÷ Average total assets
Typically small for banks, so compare with peers.

How to solve Business Models of Banks and Financial Institutions questions

Use this sequence for any question on bank or financial institution business models in a vignette.

  1. 1Identify the institution type: bank, insurer, asset manager or broker-dealer. This sets the revenue drivers.
  2. 2Locate the income statement lines in the exhibit and separate interest income, interest expense, fee income and trading income.
  3. 3Compute the needed measure: NII, NIM, spread, efficiency ratio or leverage. Use average balances if both years are given and the question asks for it.
  4. 4Check funding and liquidity on the balance sheet: deposits versus wholesale funding, loan-to-deposit ratio, liquid assets.
  5. 5Link to risk: provisions, non-performing loans, capital levels and rate sensitivity.
  6. 6Compare with the prior period or a peer and state the direction and cause of the change.
  7. 7Match your conclusion to one of the three answer options and rule out the ones that contradict the exhibit.

Quickest way: Revenue driver and funding check

When to use it: Use when a question asks which factor explains a change in earnings or how a bank differs from a corporate.

  1. Ask first: is the change from interest, fees or provisions?
  2. Compute NII and the margin only if numbers are needed; otherwise reason from the direction of rates and balances.
  3. Scan funding: more wholesale funding means higher liquidity risk.
  4. Remember that high leverage is normal for banks, so judge it against capital ratios, not against a corporate benchmark.
  5. Eliminate options that apply corporate ideas such as current ratio or working capital.

Common mistakes in Business Models of Banks and Financial Institutions

  • Using the current ratio or working capital to judge a bank

    Habit from corporate analysis.

    Fix: Banks have unclassified balance sheets. Use liquidity, funding and capital measures instead.

  • Confusing NIM with interest spread

    Both measure profitability from interest.

    Fix: Spread is asset yield minus funding cost. NIM is NII divided by earning assets and includes the benefit of free funds like equity.

  • Dividing NII by total assets and calling it NIM

    It is the easiest number on the page.

    Fix: Check whether average interest-earning assets are provided and use them.

  • Treating loan growth as always positive

    Growth is good for corporates.

    Fix: Read loan growth with provisions, non-performing loans and funding. Rapid growth with falling provisions can signal weak credit standards.

  • Treating high leverage as a red flag by itself

    Corporate debt ratios look similar.

    Fix: Leverage is inherent in banking. Judge it against regulatory capital, asset quality and funding stability.

  • Applying bank logic to insurers

    Both are called financial institutions.

    Fix: Insurers earn from underwriting and investing premiums. Look at claims, expense and investment income.

Worked examples

Example 1

Vignette: Bank A reports interest income of 840, interest expense of 360, fee income of 180 and non-interest expense of 390. Average interest-earning assets are 12,000. Average interest-bearing liabilities cost 3.0%. Q1: What is NII? Q2: What is NIM? Q3: What is the efficiency ratio?

Show the solution
  1. NII = 840 − 360 = 480.
  2. NIM = 480 ÷ 12,000 = 4.0%.
  3. Total revenue = NII + fee income = 480 + 180 = 660.
  4. Efficiency ratio = 390 ÷ 660 = 59.1%.

Answer: NII is 480, NIM is 4.0%, and the efficiency ratio is about 59.1%.

Example 2

Vignette: Bank B has loans of 9,000, deposits of 7,500, total assets of 14,000 and equity of 700. Bank C has loans of 6,000, deposits of 8,000, total assets of 12,000 and equity of 900. Q1: Which bank has the higher loan-to-deposit ratio? Q2: What is Bank B's equity multiplier? Q3: Which bank relies more on wholesale funding, other things equal?

Show the solution
  1. Bank B loan-to-deposit = 9,000 ÷ 7,500 = 1.20, or 120%.
  2. Bank C loan-to-deposit = 6,000 ÷ 8,000 = 0.75, or 75%.
  3. Bank B has the higher ratio.
  4. Bank B equity multiplier = 14,000 ÷ 700 = 20.
  5. Loans exceed deposits at Bank B, so the gap must be funded by non-deposit sources, meaning wholesale funding.

Answer: Bank B has the higher loan-to-deposit ratio (120% versus 75%), its equity multiplier is 20, and it relies more on wholesale funding.

Exam tips

  • Read the vignette for the institution type before doing any math.
  • Check whether the question wants NIM or spread. The denominators differ.
  • When two answer options both sound sensible, pick the one that uses bank-specific measures such as capital, funding or asset quality.
  • Use average balances when both opening and closing figures are given and the question implies a period measure.
  • Expect to explain why a change happened, not only to calculate it.

Business Models of Banks and Financial Institutions in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Business Models of Banks and Financial Institutions: frequently asked questions

How do banks make money?

Mainly through net interest income, the gap between interest earned on loans and securities and interest paid on deposits and borrowings. They also earn fees, commissions and trading income. The mix varies by bank.

How is a bank's balance sheet different from a corporate's?

A bank does not split items into current and non-current. Assets are mostly financial, such as loans and securities, and liabilities are mostly deposits and borrowings. Leverage is much higher and equity is a thin buffer.

What is the difference between NIM and interest spread?

Spread is the yield on earning assets minus the cost of interest-bearing liabilities. NIM is net interest income divided by average earning assets. NIM is usually higher than the spread when part of the funding is free, such as equity.

Do I need to memorize regulatory ratios for this topic?

This topic focuses on the business model and how analysis differs from corporates. The capital and CAMELS details are covered in related topics, so study them together.