Are banks too profitable? Or not profitable enough?

Andrew Cornell

Past Managing Editor, bluenotes

According to the European Central Bank (ECB), banks need to make more money. It’s not a line you’d hear widely, particularly not in Australia.

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Admittedly, unlike in Australia where taxpayers made half a billion off the banks during the financial crisis, Europeans had to bail out whole ranks of the banking sector and the financial system remains brittle.

"A healthy financial system is a profitable one, and there are numerous risks to navigate.” - Steenis

In the words of the ECB:

“Profitability is a concern for banks and an issue that supervisors, too, need to take into account when assessing the viability and sustainability of banks’ business models. Moreover, profitable banks are more attractive to investors. They can increase their capital ratios by retaining earnings or accessing the markets directly - which can be critical when they’re required to adjust capital levels to meet future supervisory expectations. Profitable banks also have the means to invest in new technologies and sound risk management. However, there is one important caveat: consistent, exceptionally high profitability can also point to hidden risks, and supervisors will keep this in their sights.”

So the ECB is not a fan of unfettered profits - albeit because that may be signal of hidden risks rather the profiteering courtesy of competitive barriers or rents.

Across the - soon to be much wider - English Channel, banking profitability or the looming lack thereof is also on the mind of the central bank. English taxpayers too continue to pay for the collapse of many banks in the financial crisis.

Investment needed

The Bank of England has just released its response to an extensive piece of research into the future of finance by Huw van Steenis.

The response, “New Economy, new finance, new Bank”, identifies five key areas of attention:

A more resilient innovative and competitive payments system for households and businesses
The small to medium-sized business funding gap
An orderly transition to a carbon-neutral economy
A world-class regtech and data strategy
Greater resilience and adoption of the cloud and other new technologies

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Source: Bank of England

Critically, all these priorities require investment dollars and not just a change in strategy. The best placed organisations to satisfy the demands of the future may not even be traditional banks.

Well, so what? Capitalism is all about creative destruction. However, the challenge - as Steenis notes - will come in the transition.

Dip their toe

In his report Steenis draws out the implications of a shift in financing away from incumbents and the entry of, as-yet-untested, new competitors.

Consider the implications of a separation of payments and lending from deposit-taking and the implications for the core banking system, he writes.

“A healthy financial system is a profitable one, and there are numerous risks to navigate. Regulators have to watch out for new platform-based businesses outside finance entering parts of financial services if they take on risks deemed as regulated activities,” Steenis says.

“For instance, today the Big Tech firms are only dipping their toes in financial waters. The implications if they dive in could be profound. This could shift the focus from the current entity to greater emphasis on activity-based approaches. Policymakers will also need to consider the implications for monetary policy of a different banking model.”

At the very least, the entrance of new competition compresses operating margins - which is fine as long as those institutions doing the compressing are viable through a full economic cycle.

As Steenis writes: “The extent to which more profitable activities migrate, or how far competition compresses margins, will have implications for the viability of some business models.”

The most profitable value-chains are the ones start-up fintechs and the massive platforms - bigtech - are looking at.

“Although take-up has so far been slow, (fintech) proponents argue that Open Banking could create further competition. PwC predicts that 40 per cent of banking revenues could be at risk from fintech” Steenis says.

Expanding universe

It’s true that to date fintechs have only made incremental inroads into financial services while bigtech - which has the scale, resources and data - struggles with issues of public trust and the regulatory force of privacy, anti-money laundering and licencing.

Nevertheless, the fintech universe continues to expand. According to the latest CB Insights Global Fintech Report, venture capital-backed fintech start-ups raised $US8.3 billion in funding in the second quarter of 2019.

While the expansion has slowed - Asian deals fell back - so-called challenger banks raised $US649 million across 17 deals in the quarter and should top the funding record set in 2018.

High enough

Now businesses and households care about the function of the financial system, not the institutions which provide the functions. A person wants to buy a house, not a mortgage from a particular bank. A small business wants to purchase stock for a special promotion, not buy an overdraft.

Healthy economies rely on the aggregate of this demand but they also require more mundane services like payments systems and basic transaction accounts.

In the current model financial system, institutions like banks provide a basket of services, the more profitable cross-subsidise the necessary but non-economic.

That supports a level of profitability which in turn provides stability to the financial system. It also means investors are attracted to invest the equity capital necessary for a prudentially sound bank.

And those equity investors include - either directly or via institutional funds - the same households and businesses which borrow money, loan a bank deposits and make payments.

So what’s the right level of profitability for the banking system? The basic answer is high enough to justify the risk of buying shares in banks.

To take the ECB approach, banks need to be profitable enough to generate sufficient retained earnings to build their capital to a level which attracts equity investors.

The global bank regulator, the Bank for International Settlements, notes the cost of capital for banks in Europe is between 6 and 8 per cent. Returns on equity of 6 per cent are insufficient - European banks are not profitable enough.

In Australia, various analysts put the cost of capital at between 10 and 12 per cent. According to PwC’s analysis of the major Australian banks’ interim results, return on equity was 12.5 per cent - down 144 basis points year-on-year.

Temptation

Maybe at some point in the future the financial system will be compromised of myriad, specialist payment, mortgage, deposit taking and venture capital firms. Today, and for the foreseeable future, the system relies on banks.

As ECB vice president Luis de Guindos said at a recent conference “so why does low bank profitability matter for financial stability?”

His answer: “Perhaps most importantly, persistently low profitability can limit banks' ability to generate capital organically. This makes it harder for them to build up buffers against unexpected shocks and limits their capacity to fund loan growth. At the same time, banks with weak profitability prospects and low market valuations could find it very costly, or even prohibitively expensive, to raise capital from market sources should the need arise.

“In addition, banks with limited current earnings power may also be tempted to take on more risk.”

The only thing worse than profitable banks is unprofitable banks.

Andrew Cornell is managing editor of bluenotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.