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.
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