Financial profits in the US are very high; they now amount to about one-third of all company profits, compared with less than 5% 20 years ago. Financial profit margins are at peak levels – about 25% above average – and, given that such margins tend to revert to their mean, it is unlikely they can be sustained. A similar view emerges from the apparent connection between the rise in financial profit margins over the past 20 years and the accompanying fall in interest rates. Analysis of the sources of bank profits and the prospects for each main contributor points to the same conclusion.
Different risks
Banks generate income from three main sources: returns from credit operations after bad debts; returns from maturity transformation (borrowing short and lending long) and “non-interest” income. The first two engender different types of risk and can, to some extent, act as countervailing forces for one another. When the economy is weak, maturity transformation profits should be high but bad debts tend to hit credit activities. Conversely, in times of prosperity, rising short-term interest rates bring lower profit from holding securities, but this is usually offset by falling bankruptcies.
In recent years, however, this type of balance has not been needed because profits have been generated by lower interest rates and a marked decline in the reserves deemed necessary to cover defaults. Looking forward, banks’ profits are threatened by this situation in reverse.
Profits from taking credit risks have been boosted not only by the low level of defaults but also by the banks’ ability to offload these risks on to hedge funds and other investors, notably by parcelling these into packages and selling the higher risk part, or all of the package, via collateralised loan obligations. This relatively novel practice may provide good support for profit this year but the appetite from buyers seems likely to diminish, either because the market becomes saturated or because the risks to buyers become more widely discussed and appreciated.
Profits from loans retained on banks’ balance sheets are likely to become less profitable, simply because they have been boosted by a steady decline in loan reserves. These fell by $2.85bn between the third quarter of 2002 and the third quarter of 2003 but the pace had slowed to $52m in the year to the third quarter of 2004. The benefit, which is now coming to a halt, could easily reverse if loan defaults rise from their exceptionally low current level.
Default rates are low despite the continued rise in debt among households and private businesses in the US. At the end of March, household debts stood at $10,515bn and business debts at $7968bn. These are 86% and 65% of GDP respectively and, in the first quarter of this year, both were growing faster than GDP.
The third source of bank profits – fee income – seems to have benefited from the strong demand for credit risk from non-banks and from the encouragement for refinancing provided by buoyant bond and equity markets. The latest report from the US Treasury, however, shows that while the rise in non-interest income kept pace with the risk in non-interest costs in 2002 and 2003, it began to drop back last year.
The threat of inflation
The combination of high debts and low defaults is due to the benefits of the fall in debt servicing cost resulting from lower interest rates. The Federal Reserve, as the latest testimony of its chairman, Alan Greenspan, shows, is concerned about the threat of inflation, suggesting the economy is operating at near to full capacity.
Without a slowdown in growth, which would increase the risks of loan defaults, we must anticipate a continuing rise in interest rates. Therefore, the outlook for bank profits is poor whether the US economy grows or slows. If it grows, maturity transformation profits will be put under continued strain without an offsetting fall in credit losses. If it slows, credit losses are likely to increase. Stagflation would create the worst of all possible worlds.
Andrew Smithers is the chairman and George Leventis is a researcher at Smithers & Co
