How Banks Work and How to Analyze Banking Stocks

Understanding how banks operate is fundamental to evaluating banking stocks. This post covers the fractional reserve banking system, how banks generate revenue, the key ratios used to analyze banking stocks, and a comparison of the world's top 10 banks by market capitalization.

Related: If you are unfamiliar with the different categories of banks, read Types of Banks in the USA Explained first.

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Fractional Reserve Banking

The Monetary Multiplier Effect

The monetary multiplier describes how an initial deposit creates a much larger total money supply through repeated lending cycles. The formula is straightforward:

Money Multiplier = 1 / Reserve Ratio

If the reserve ratio is 10% (0.10), the multiplier is 1 / 0.10 = 10. This means a single $1,000 deposit can generate up to $10,000 in total money supply across the banking system.

How the Fractional Reserve Banking System Works

Suppose a person deposits $1,000 in a bank. The bank is required to keep a fraction of that deposit in reserve — set by the central bank's reserve ratio — and can lend out the rest. If the reserve ratio is 10%, the bank keeps $100 and lends the remaining $900.

The borrower takes the $900 and pays it to another person, who deposits it in a bank. The banking system has now created $900 that did not exist as a separate deposit before. The second bank keeps 10% of that deposit ($90) in reserve and lends out the remaining $810.

That $810 eventually gets deposited in a bank as well. The bank keeps 10% ($81) and lends out $729. This cycle continues, with each round creating a smaller amount of new money.

After enough rounds, the original $1,000 deposit has generated up to $10,000 in total deposits across the banking system — matching the multiplier of 10.

Banks that lend to riskier borrowers at higher interest rates can grow faster than banks focused on low-margin lending such as mortgages, but they also take on more default risk.

This system creates a vulnerability: if all depositors demand their money back at the same time, the bank does not have enough cash on hand to pay everyone. This is called a bank run. To prevent this, the Federal Reserve and other central banks act as lenders of last resort, provide deposit insurance, and conduct regular stress tests to verify that banks can withstand financial shocks.

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How Banks Earn Money

A bank's core business model is built on a simple concept: accept deposits from customers and lend that money to borrowers at a higher interest rate. The bank keeps the spread between what it earns on loans and what it pays on deposits. This spread — called the net interest margin — is the primary source of revenue for most banks.

To understand how banks generate this revenue, it helps to look at the two categories of loans they offer and how interest rates vary across them.

Secured Loans

In a secured loan, the borrower pledges an asset — such as a house, car, or gold — as collateral. If the borrower stops making monthly payments, the bank can seize and sell that asset to recover the outstanding balance. Mortgages, auto loans, and gold-backed loans all fall into this category. Because the collateral reduces the bank's risk, interest rates on secured loans are lower than those on unsecured loans.

Unsecured Loans

Personal loans and credit card balances have no collateral backing them. If the borrower defaults, the bank has no asset to seize and must either pursue collections or write off the loss entirely. This higher risk is why unsecured loans carry significantly higher interest rates.

Interest Rates by Loan Type

A straightforward rule governs loan pricing: the greater the risk to the bank, the higher the interest rate it charges. Below is how common loan types rank from lowest to highest rates.

Mortgage — The lowest rates of any loan type. Real estate serves as collateral and generally appreciates over time. If the borrower defaults, the bank forecloses on the property and sells it to recover the balance. Loan terms typically range from 15 to 30 years in the United States.

Auto loan — Rates are higher than mortgages because a car loses value over time. Loan terms are shorter, usually 3 to 7 years.

Student loan — Federal student loans in the United States carry fixed rates set by Congress. Repayment typically begins after the borrower finishes their education. Private student loans have higher rates that vary by lender.

Gold loan — Gold serves as collateral and is widely considered a safe-haven asset, which keeps interest rates relatively low.

Personal loan — Rates typically range from 6% to 36%, depending on the borrower's credit score. No collateral is required, so the bank assumes more risk.

Small business loan — Rates vary widely based on the borrower's creditworthiness, business revenue, and the loan's structure.

Credit card — The highest rates of any loan type, often ranging from 20% to 30% APR. If the cardholder pays the full statement balance each month, no interest accrues. Carrying a balance, however, results in compounding interest charges on the unpaid amount.

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Non-Performing Loans (NPLs)

When a borrower fails to make payments on a loan for 90 days or more, that loan is reclassified as a non-performing loan (NPL). The bank can no longer count the expected interest as revenue, and the loan weighs on the bank's balance sheet.

A high percentage of non-performing loans indicates that a bank has either made poor lending decisions or is operating in a stressed economic environment. Either way, it is a warning sign for investors.

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How to Analyze Banking Stocks

Analyzing banking stocks requires a different set of metrics than most other sectors. Standard ratios like P/E still apply, but several banking-specific ratios are essential for evaluating a bank's profitability, asset quality, and financial stability.

Before you read: If you are new to financial ratios, these guides cover the fundamentals:

• Valuation Ratios Explained: P/E, P/B, EPS, PEG, and P/S
• Profitability Ratios Explained: ROE, ROA, ROCE, and Margins

P/B Ratio (Price-to-Book Ratio)

The P/B ratio compares a bank's stock price to its book value per share. For banks, this is the most important valuation metric because their assets and liabilities are mostly financial instruments recorded near actual market value. A P/B below 1.0 signals concerns about asset quality; above 1.0 means the market expects the bank to earn returns above its cost of equity. For a detailed explanation, see Valuation Ratios Explained.

CASA Ratio

CASA stands for Current Account and Savings Account ratio. It measures what share of a bank's total deposits comes from current accounts (which pay 0% interest) and savings accounts (which pay low interest, typically around 3%).

Formula: CASA Ratio = (Current Account Deposits + Savings Account Deposits) / Total Deposits

A higher CASA ratio is better because it lowers the bank's overall cost of funding.

Example: A bank holds $100 billion in total deposits, sourced primarily through low-cost checking and savings accounts at an average cost of 2%. If the bank lends this money at 6%, it earns a 4% spread — roughly $4 billion in net interest income. If the same bank had raised its deposits through certificates of deposit (CDs) at 4%, the spread would shrink to 2%, cutting net interest income in half.

Non-Performing Loans: Gross NPL vs. Net NPL

Gross NPL is the total value of all loans where payments are overdue by 90 days or more. Net NPL subtracts the provisions — reserves the bank has already set aside to cover expected losses — from the gross figure.

Gross NPL Ratio = Gross NPL / Total Loans

Net NPL Ratio = (Gross NPL − Provisions) / (Total Loans − Provisions)

Example: A bank has $500 billion in total loans. Of that, $5 billion is classified as non-performing (Gross NPL), and the bank has set aside $3 billion in provisions. The Gross NPL ratio is 1.0%. The Net NPL ratio is (5 − 3) / (500 − 3) = 0.40%.

Banks with lower NPL ratios demonstrate stronger underwriting standards — they are better at assessing which borrowers are likely to repay and which are not.

Cost of Funds

The cost of funds represents the average interest rate a bank pays across all of its funding sources, including deposits, interbank borrowings, and other liabilities.

Example: A bank holds $100 billion in total deposits. Of that, $25 billion comes from current accounts at 0% interest, $50 billion in savings accounts at 0.45%, and $25 billion in CDs at 4.5%. The weighted average cost of funds works out to approximately 1.35%.

A bank that reports a high CASA ratio but still has a high cost of funds is a red flag. It suggests the bank is relying on expensive wholesale funding or promotional deposit rates to attract customers.

Loan Growth

Loan growth measures the year-over-year increase in a bank's total outstanding loans.

Example: If a bank had $100 billion in outstanding loans last year and $120 billion this year, its loan growth rate is 20%.

Steady loan growth signals that a bank is expanding its business and gaining market share. However, excessively rapid loan growth can be a warning sign — it may indicate the bank is lowering its underwriting standards to chase volume.

CAR: Capital Adequacy Ratio

The Capital Adequacy Ratio measures a bank's ability to absorb losses and protect depositors. It reflects the size of a bank's capital cushion relative to its risk exposure.

Formula: CAR = (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets

Regulators require banks to maintain a minimum CAR, typically 10% to 12% under the Basel III international framework. A bank with a higher CAR has a larger buffer against unexpected losses and is considered more financially stable.

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World's Top 10 Banks by Market Capitalization

The following table ranks the world's 10 largest banks by market capitalization as of August 2026. The data is sourced from CompaniesMarketCap and StockAnalysis.

Ratios such as NIM, CASA, NPL, cost of funds, loan growth, CAR, and loan-to-deposit ratio are not included in this comparison because global banks follow different accounting standards and disclosure formats, making direct comparisons unreliable. These metrics are best used when analyzing individual banks within the same country or regulatory framework.

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Conclusion

Banking runs on fractional reserve lending — one deposit creates multiples of itself through successive lending cycles. A bank's profitability comes down to the spread between what it earns on loans and what it pays on deposits. NPL ratio, P/B, CASA, and capital adequacy are the key metrics for comparing banking stocks. US banks lead global rankings by market cap, while Chinese banks trade below book value with P/E ratios under 7. Understanding these fundamentals helps investors separate well-managed banks from those carrying hidden risk.

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Sources and References

Market Data

• CompaniesMarketCap — Largest Banks by Market Cap — Market capitalization and P/B ratio data as of August 2026
• StockAnalysis — P/E ratios, ROE, and dividend yield data for US-listed and HK-listed banks

Regulatory and Educational References

• Federal Reserve — How Banks Work — Overview of the US banking system and reserve requirements
• FDIC — Deposit Insurance and Bank Data — US bank financial data and deposit insurance rules
• Bank for International Settlements — Basel III Framework — International capital adequacy standards
• Investopedia — Net Interest Margin — Definition and calculation of NIM
• Investopedia — Price-to-Book Ratio — P/B ratio explained
• Investopedia — Return on Equity — ROE definition and benchmarks
• Investopedia — Capital Adequacy Ratio — CAR formula and regulatory minimums
• Investopedia — Non-Performing Loan — NPL classification and impact on bank financials

All data is subject to change based on market conditions.

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This analysis is for educational purposes only and does not constitute investment advice.