Are the banks excesively profitable?

A widely used measure of profitability in business, particularly for shareholders, is return on equity. This is because it measures the return on all the money that shareholders have put into the business, including their profits that the company has made and reinvested into itself. It is often preferred to ratios like return on assets because it takes into account the advantage of leverage which can increase returns: when making an investment it is not the return on the asset you bought which matters, it’s the return on the amount of money you put into the investment (your equity).

The return on equity ratio also makes it easy to compare companies in so far as seeing how well they can use the cash they were given to generate profits, which is after all what the shareholder wants them to do. Return on equity is also generally positively related to debt to equity ratios. A firm that utilises more debt than equity to fund its assets will simply have less shareholders with equity to spread profits over, so more profits for each shareholder. The amount that the firm must pay a debt holder in return for giving the firm his funds (the interest rate) is generally less than the amount that the firm must give a shareholder (in the form of dividends) due to the fact that debt is a senior form of funding relative to equity. This simply means that in the event o bankruptcy, the debt holder will get paid back his money before a shareholder who will generally rank last in this queue (assuming there’s anything left for either of them). The lower return also stems from the fact that debt has a fixed, unchanging return in the interest rate, whereas dividends can go up, down or ceased altogether. This reduces the risk for a debtholder by providing certainty of cashflows, and hence lowers the required return. This equates to more profits left over for the company if it chooses debt over equity. Interest payments on debt are also tax deductible, whereas dividend payments on equity shares are not. The tax reducing properties of debt also mean higher profits if a firm chooses debt over equity. Largely due to these three points debt tends to reduce the amount of equity and increase profits, which increases ROE (profits/equity) and results in more profits for you and me.

These are the same reasons property investors borrow to buy a house. They don’t have to put in as much of their own money (less equity to spread profits over), the bank only wants at the moment about eight percent or so return on the money it gives you in the form of a loan whereas people often like to think they’ll make around twenty percent per year on the money they put into an investment property (lower return on debt than equity), and finally the interest payments on loans come straight off people’s taxable income.

So what stops people from leveraging up to the hilt to maximise profits and returns on shareholders’ equity. Unfortunately not a lot if the GFC is anything to go by, but it should be obvious to most that having debt is a risk. Debt must be paid before the owners of the company (equity holders) get paid, so if there isn’t enough profits to go around equityholders get burned. So companies can generate higher returns by taking on more debt, but this increases risk.

Now to the point. There’s a lot of political “debate” at the moment (I don’t think the rubbish politicians talk, deserves a word with quite so much intellectual “feel” to it but that’s what they call it on the telly) about how obscenely “profitable” the banks are at the moment, and you’re hearing a whole lot of big numbers going around like 5.66 billion dollars and even bigger phrases like “record profits at Australians’ expense”. $5.66 billion dollars sound like a lot of money, but that’s right, I’m gonna tell ya it’s not (sometimes ya gotta be mainstream to be contrarian). Now here’s why.

Equity holders and debt holders have put an extraordinary amount of capital into the business to generate it. Particularly debt holders. A simple return on assets for National Australia bank, commonwealth bank, Westpac and ANZ are 0.62%, 0.88%, 1.04% and 0.85% respectively. What’s more their ROEs are 11%, 16%, 16% and 13%. Their debt to equity ratios are 1112% 1457%, 1240% and 1060%. Are these numbers big or small?

Compare them to JB Hi Fi, who has a return on its assets of 17% and a return on equity of 40%. But as discussed a firm can engineer high ROE with high debt levels and hence higher risk. Is that JB’s secret? No. It manages to generate such high returns for shareholders with a debt to equity ratio of just 6%. These figures are reproduced below for easy comparison.

METRIC	NAB	CBA	WBC	ANZ	JBH
ROA %	0.62	0.88	1.04	0.85	17
ROE %	11	16	16	13	40
NET D/E %	1112	1457	1240	1060	6

A bank by the very nature of its business is always going to be very highly leveraged; it borrows money from people and then lends it out. This is a very important function that ensures that borrowers can find savers easily, and it is unlikely that similar rates of economic growth could be achieved without our complex financial system. But it doesn’t change the factors that make debt a risk for an equity shareholder in a bank, namely that the debt gets paid back first, whether there’s enough profits to go round or not. For the astonishing leverage that banks take on they are miserably unprofitable for their shareholders. This can be seen by applying ANZ’s leverage to JB’s balance sheet (ANZ being the bank with the lowest net debt to equity ratio).

If JB Hi Fi leveraged its balance sheet to the extent that ANZ did, and was able to deploy all the raised capital (from issuing all that debt) at the same rates, it would have a return on equity of 258%! And this doesn’t take into account the positive effect on margins of the deductibility of interest payments for tax purposes (for an explanation of where this and other numbers in this blog came from see Are banks excessively profitable data).

Companies who want to leverage up can also issue debt and buyback shares to dissolve with the proceeds, which is simply good because it means there are less shares to distribute profits over. If JB Hi Fi were to leverage to a level similar to ANZ’s they would have to issue $3,091,048,000.60 worth of debt, enough to buyback all the shares, and then nearly enough to buy them all back a second time (if that were possible). Of course they’d have to buy them all up because no-one in their right mind would invest in JB Hi Fi, it’d be too risky!

JB Hi Fi and ANZ are completely different businesses and this is an extreme example to illustrate the point. Comparing ratios across industries like this is a dangerous game and is no basis for an investment, but the point is that banks aren’t that profitable, and when you take into account the amount of debt they use, they are anything but. Next time you hear someone screaming at you that banks make obscene profits (and people do scream when it comes to this topic) you can tell them that banks are a far cry from the most profitable entities on the ASX, and if they think it’s such a great deal then they should buy some shares themselves. They’ll probably tell you that all their money’s tied up in their house.