Confusion about bank profits

The most misunderstood aspect of the banking sector involves profitability. The confusion concerning bank profitability relates to the absolute rather than relative information reported; newspapers are filled with articles stating that the banks earned record profits totalling billions of dollars. For instance, the absolute value of the earnings of the Royal Bank of Canada of $1.43 billion in 1996 is almost surreal due to its sheer size. However, the absolute figure is misleading; the objective evaluation of a firm's profitability exists in relative information.

The two commonly employed relative statistics measuring profitability are return on assets (ROA) and return on equity (ROE). Essentially, what these two relative measures indicate is how much an investor earned for each dollar invested (ROE) and the amount of earnings generated given the level of assets employed by the firm (ROA). In relative terms, the Royal Bank of Canada generated 17.6 cents for every dollar invested by its owners and earned 0.74 cents for every dollar of assets employed (table 1). In relative terms, the performance of the banks does not indicate the presence of monopoly rents or extraordinary profits but rather normal, competitive profitability.

Canadian banks in 1996 contributed almost one-fifth of all corporate taxation collected, and the top five chartered banks alone contributed $3.7 billion in corporate taxes before any profits were distributed to the owners or retained for reinvestment. The punitive taxation levied on the banking industry through a 12 percent surcharge on profits and the disallowance of software expenditures as research credits does nothing to stimulate economic activity. The additional taxation taken by the government could have been used to invest in new technology, better train employees and upgrade operating systems, allowing the banks to become more productive and profitable, thus increasing the total amount of taxation paid at the normal rate of corporate taxation (application of the Laffer Curve).

The effect of technology

The second myth relates to the effect of technology on employment and wages. People generally believe that technology and innovation substitute rather than augment labour, thus reducing employment and pushing wages down. A common adage associated with banking is that as instant tellers, internet, and telephone banking expand, the employment base of the industry will deteriorate. However, as table 2 illustrates, with the exception of the Royal Bank of Canada and the Canadian Imperial Bank of Commerce, the exact opposite has occurred.

The accumulation of technology and innovation eliminates labour-intensive, low paying jobs and replaces them with capital-intensive, higher paying positions. As inefficient positions are eliminated, the firm expands its services and its employment

base in order to help expand its revenues and profits. This process has occurred to only a limited extent in the banking sector due, in part, to regulatory constraints and punitive taxation rates. However, as banks have gained access to new markets, developed new products, and created technological improve-ments, the traditional lower paying positions, such as tellers, have been replaced by higher paying, value-added positions, such as retirement advisers, personal invest- ment managers and mortgage specialists.

The increase in wages during the period highlighted in table 2 is remarkable; average annual employee wage growth for the five largest banks was 7.26 percent, while inflation averaged 1.42 percent for the same period, resulting in an average annual real increase in wages of 5.84 percent. Similarly, job creation averaged 0.69 percent, while the increase in the number of new instant teller machines averaged 20.92 percent for the five year period and 246.93 percent for the ten year inclusive period. The net effect of technology and innovation has clearly been an expansion in both employment and real wages.

Reluctance to grant loans

Another popular criticism of the banking industry is its supposed reluctance to grant credit (loans) to newly formed and small-sized businesses. Opponents of free market banking state that banks should be forced, through legislation, to lend greater amounts of money to small business and isolated regions. This type of policy is not only misguided but fundamentally flawed given the nature of the industry. The financial services industry acts as an intermediary, rather than as a direct participant in the market, and the banking sector's primary function is to facilitate the exchange of funds between savers and spenders for the purposes of consumption and investment. Profits are generated by the spread between what the banks pay for the use of the surplus funds, and what the bank charges the users of the funds. The spread must be large enough to cover all of the expenses (interest and non-interest) plus provide for a reasonable return to the shareholders.

Those who argue for more small business loans assume that the banks currently choose to reject some profitable loans, or that they are able to internalize a greater level of risk in their loan portfolio than they do now without adversely affecting loan losses or interest rates. Bank shareholders, like shareholders of other businesses, do not discriminate in their search for profitability, and therefore demand that banks maximize their personal wealth by generating ever-increasing profits, regardless of the source. Competitive pressures force banks not only to accept but to compete for profitable loans. This effectively rejects the first basis of the criticism.

Even with due diligence, which includes various control mechanisms, security monitoring, and extensive research, banks still incur loan losses—$3.067 billion in 1996. Table 3 indicates the total cumulative level of non-performing loans (gross impaired), the cumulative amount of non-performing loans after accounting for recoveries and adjustments (net impaired) and the expected amount of non-performing loans (allowance for credit losses). All three figures, by their comparative value to net income, represent a material threat to bank profitability. It is important to recognize that loan losses in 1996 occurred within an environment of economic growth and strict diligence on the part of most banks.

Those who argue for greater loan allocations to small businesses and isolated regions of the country ignore the potential detrimental effects that loan losses can have on the ability of both banks and the economy to generate wealth and economic growth. For instance, if Bank A possesses 100 loans valued at $1,000 each, and earns a 1.00 percent spread, it cannot afford to lose even one loan. The default of one loan would result in a net financial loss for the bank. The total income generated by the portfolio ($1,000) would be completely negated by the default of one loan, while the normal costs associated with the operation of the bank, such as interest costs, salaries, and other overhead expenses would still be incurred, thus generating a financial loss.

This loan loss would necessitate an increase in the interest rates charged to all customers. In essence, productive, viable companies would subsidize less worthy customers through higher interest rates. The real reason why newly formed, small businesses cannot obtain traditional bank loans is the lack of equity and readily realizable security present. However, the market system has developed alternate financing arrangements for small business start-ups, such as venture capital funds and small capital financing. Coercive lending policies would do absolutely nothing to stimulate economic growth or job creation. Rather, they would stifle the investment and entrepreneurial environment which creates wealth and employment.

The banking industry, like other sectors of the economy, operates most efficiently—that is, it creates the greatest level of wealth, employment, and productivity gains—when it is allowed to operate unencumbered by government regulation and special interests. The government must release the productive capacity of the banks and other financial institutions in order to spur economic growth, job creation, and the accumulation of wealth.

In the coming parliamentary session, the sleeper issue to watch for is changes in the regulation of financial institutions which allow for greater foreign entry and increased concentration of bank ownership.