Thursday, 25 August 2011

Bank Profits & Leverage

There is something peculiar about banks. They borrow cash from people, companies and governments, and lend to people, companies and governments. They deliver ‘financial services’. But, in the process, the closest they ever come to producing anything is when they provide the funds for somebody else to do the producing. Despite this, they gain a great deal of profit. This article is about bank profits and the influence on profits of leverage.

The nature of banks

The modus operandi of banks has traditionally been to attract surplus funds from the broad economy, and to pay interest on these funds at a rate less than they will earn from investing these funds. In the past couple of decades, however, an increasing proportion of bank profits has come from financial activities beyond simple borrowing and lending. Banks might also take fees from companies when issuing their bonds or equities to other investors, or for giving advice on mergers and takeovers, or they might profit from their own dealing in currencies, interest rates, commodities and derivatives. Nevertheless, banks are in the business of financial market transactions, at most speculating on or taking a cut from what other people are producing, rather than producing anything themselves.

Banks do produce for themselves an often impressive profit, but that is based on deriving revenues from business undertaken elsewhere. Even when banks provide critically needed financing, or offer advice and deals that save a company money compared to what it might otherwise have done, the profit they make is based on the surplus that some other business has made. For the UK, the US and some other financial powers, this parasitic role is not seen as a disadvantage. In those countries, the banking system is seen as a key part of the strength of the domestic capitalist economy. This is because their banks can attract significant revenues from other countries. It doesn’t matter where the wealth is produced; it only matters where it is appropriated.

Profits & leverage

Compared to industrial and commercial companies, banks have a big advantage when it comes to making profit. They can use their privileged position in the financial system to borrow at relatively low cost, whether from individual savers, from companies, or from state funding via the central bank. Given the billions of transactions they undertake, they can also count on support from the state when things go wrong, especially if they are ‘too big to fail’. Trouble for the banks means trouble for the capitalist market system.

Bank profits derive from the difference between their borrowing costs and the earnings on their investments. Also, the more they borrow, the more earnings potential they have – via loans, trading positions, taking the risk of underwriting securities, etc. The only limit to such borrowing is when it looks ‘too high’ compared to the underlying investment, or equity, in the bank itself. More borrowing means that a bank can use the funds to buy more assets on which to make a return. This increases the bank’s ‘leverage’, the ratio of its total assets to its equity capital. But as the leverage rises, the bank risks losses on its investments that might eat into its underlying capital - eventually making it insolvent.

As for many other notions in finance, the definition of excessive leverage is a flexible one, determined by what is considered to be ‘normal’.[1] It turns out that a leverage ratio of up to around 20 for banks is considered fine, since this has not been associated with big losses in the past. The risk of loss increases when there is a lot of borrowing at a fixed cost of funds against assets that have a variable rate of return. Higher leverage means that a small drop in earnings on assets – especially through non-payment of debt or default - can wipe out profits completely, since the costs of the borrowed funds still have to be paid.

Leverage is used by industrial and commercial corporations, as well as by banks and other financial companies. However, the former have little ability, unlike the banks, to attract cheap funding, and in any case are more focused on production and distribution, rather than on financial transactions. Therefore they usually have much smaller leverage ratios than banks. Data for US manufacturing companies, for example, show that stockholders’ equity has been higher than corporate debt in the past decade.

To make the issue of bank leverage more clear, consider an example where a bank has $5bn of shareholders’ capital and it borrows another $95bn in the market to fund its total assets of $100bn. In this case, its ratio of total assets to equity, or leverage, is x20, because the assets of $100bn are 20 times higher than the shareholders’ capital. Things go well for the bank if its cost of funds is below the return on its assets. If it pays 4% for its funds, the interest bill is $3.8bn, whereas if it earns 5% on its assets, the return is $5bn. What looks like a small 1% margin of return generates a net income of $1.2bn, and this is measured against the $5bn of equity. So the return on equity is 24% (the $1.2bn divided by $5bn). It would be lower if the costs of its operations are included, but these are excluded in these examples to simplify the picture.

If the bank then expands its business by borrowing even more, it can potentially boost its returns dramatically. For example, if it borrowed $195bn then, with its $5bn of equity, it could fund $200bn of assets. The leverage ratio would now be x40. If the cost of funds were still 4%, it would have to pay a massive $7.8bn in interest on the $195bn, but it would receive $10bn in revenue if the rate of return on the $200bn were still 5%. This gives a net $2.2bn of revenue against the $5bn of equity, thus a return on equity of 44%. Here, the increase in leverage has worked and the return on equity has soared. But the risk was that the assets might not return as much as the previous 5%. Once the average return falls below 3.9%, not much of a drop, the bank starts to make a big loss.

This example of increased leverage might look extreme, but something like this, or worse, was going on in the speculative boom of the 2000s. Up to 2007-08, banks in all the major countries increased their borrowing from financial markets to fund more investments and boost their profits. This borrowing pushed their leverage ratios from around the x20 level to extraordinary heights. Chart 1 shows that in 2007-08, the average leverage ratio was x40 or higher in the US and Europe, with the assets of some large banks even reaching x60 or x100 compared to their equity.

Chart 1: Global bank leverage ratios, 2007-2011 *

Source: Bank of England

Notes: * The longer-term average leverage ratio is close to 20. LCFI means ‘large complex financial institution’ - essentially a big bank with diverse operations. Company accounts have been adjusted to make the data comparable between different countries.

This extreme leverage was an important dimension of the financial boom, and it accentuated the financial collapse once the delusions of ever-higher revenues were shattered. In 2008, at the height of the crisis, every major bank in the US, UK and the rest of Europe registered a plunge in profits, with the sector as whole in each region showing a loss.[2] Since 2008, banks have cut their leverage ratios sharply, by selling or writing off assets and by getting more equity capital investment. In early 2011, these ratios were much closer to their longer-term averages, though this is not to argue that the banks are by any means in a healthy financial position, given that they face rising levels of bad debts and still have huge volumes of dud assets.

Bank subsidies, post-crash

Bank profits were obviously hit by the crisis, and lower levels of leverage have now reduced their potential for ramping up profits. However, profits since the crisis have recovered to some degree, helped by state provision of close-to-zero interest rate funding in the US and UK, and by very low rates in the euro countries. Even where funds have not been directly provided by the state, explicit or implicit guarantees provided by governments have enabled many banks to get funding from the market at much cheaper rates than their real financial position would otherwise have allowed. The spread between banks’ borrowing and lending rates has also widened, increasing their interest income.

A senior Bank of England executive has done a useful estimate of the value of the ‘state guarantee’ subsidy to the major UK and global banks between 2007 and 2009:

‘For UK banks, the average annual subsidy for the top five banks over these years [2007-2009] was over £50 billion - roughly equal to UK banks’ annual profits prior to the crisis. At the height of the crisis, the subsidy was larger still. For the sample of global banks, the average annual subsidy for the top five banks was just less than $60 billion per year.’[3]

As his report put it, ‘these are not small sums’.

Imperial leverage

Previous articles on this blog have shown how declining profitability prompted capital to move away from productive investment into the easy profits of finance, leading to a credit-fuelled boom and bust.[4] The purpose of this article has been to highlight the important role of borrowing by the banks. Higher leverage ratios enabled banks to boost their profits in the upswing, but their extra assets were the debts of others. Now a lot of the debt cannot be repaid. The huge costs of the debt crisis are evident to all, and the shock to the system has led to government inquiries and proposals for reforming the financial markets. However, for the US and the UK, in particular, the financial sector is a key dimension of their economic power as imperialist countries. The US and UK financial systems play a major role in profitably financing the two chronic deficit countries. It is also, one might say, an important part of their ‘leverage’.[5] Anglo-American policy makers are not happy that the costs of the crisis are so high, but they will not do anything to undermine the position of their banks, even if they do decide to constrain some more reckless banking activities.

Tony Norfield, 25 August 2011

[1] There are different definitions of leverage, although each refers to some measure of assets versus capital. Different accounting standards also deliver different numbers. The overall trends up and down tend to remain the same, however. In this article, the basic definition used is bank assets divided by shareholders’ capital, which is the sum of the value of equity capital issued plus retained profits. Confusingly, some other measures of leverage express the ratio as the inverse of the one used here, with capital divided by assets, so a x20 leverage ratio is expressed as a 5% capital/asset ratio.
[2] See Bank of England, Financial Stability Report, June 2011.
[3] See Andrew Haldane, ‘The $100 billion question’, Bank of England, March 2010. This report is of interest for looking at the systemic costs of banking, and for calling the banking industry a ‘pollutant’ with ‘noxious’ by-products. This is from an Executive Director of the Bank of England, responsible for Financial Stability!
[4] See in particular, ‘Anti-bank populism in the imperial heartland’, 5 July 2011.
[5] The US has commonly used financial sanctions against disobedient countries, especially with regard to Iran. The UK has also made ample use of its financial influence, including, more recently, its control over Libyan funds based in London. For the role of finance for the UK, see ‘The Economics of British Imperialism’, 22 May 2011 on this blog. Some notes on the US are in ‘The Real US Debt Problem’, 26 July 2011.

1 comment:

  1. My topic for a doctoral degree is Financialization and the Debt-Creation Phenomenon...I am currently writing my Literature Review dealing with the first research objective " To evaluate the extent to which current credit creation practices enhance the profitability of the commercial banks of South AfFRICA" Can you pls recommend some academic and business articles/papers/publications.