How banks falsely justified a ten-fold increase in their profits and why they should be regulated

By Neville Bennett

In the third quarter of 2008 when Lehman Brothers crashed, the UK’s National Accounts announced a record increase in profits in the British financial sector. They said financial corporations earned an additional £5 billion (to £20 bn): the largest quarterly increase on record.

That was madness. Many banks were failing at the time and subsequently required public support, even nationalisation.

The result casts doubt on how GDP is calculated. More importantly it leads to an inquiry into bank super profits.

These are quite technical issues which some people might say are too difficult for general readers. My viewpoint is different.

There is a massive amount of research by institutions like central banks, which I read but which are generally not covered by the business press. This article is based on Bank of England research.

How value-added is calculated in national accounts

Statisticians measure the contribution of a sector (like finance or farming) by gross value-added (GVA). GVA is the residue of the gross value of output less the costs of goods and services used in production.

In the past, the finance sector was important but not especially profitable. In the UK, between 1948 and 1978, finance accounted for about 1.5% of total profits.

This has changed remarkably. By 2008, finance accounted for 15% of all profits: a tenfold increase. This has been part of an international trend.

In 2007-8 the largest 1,000 banks in the world reported pre-tax profits of US$800 bn, a 150% increase from 2000-01. Returns to bank shareholders in the UK, US and Euro area increased 150% in that time, exceeding returns in all other industries, even the risk-taking hedge funds.

How does any business or sector make profits? Profits come when income exceed costs. Some banks advise on mergers, underwrite IPO’s or help clients with broking etc. in order to earn income, but most profits come from interest flows generated by borrowing low and lending high.

Estimating the profits between paying interest on deposits and then lending the money out in loans is called Financial Intermediation Services Indirectly Measured (FISIM) and the details are not important here, except it seems to deliver some questionable results.

The accounting practices used add compensation for bearing risk. So when banks panicked in October, 2008 and raised interest rates where they could, FISIM recorded an increase in output.

Banks had mispriced risk for many years. Unless the price of risk can be evaluated properly, it is hard to measure the contribution of the financial sector.

Decomposing finance

There is an alternative way of working out the finance industry’s contribution to GDP. This follows basic growth theory: essentially growth comes from inputs of labour, capital and productivity/technical change. This explained the finance industry until the 1990’s when more capital and labour was employed.

But since about 1995, the share of capital and labour has diminished against the remainder of the economy. As value-added has increased, it appears that productivity increases are high, about 2.2% p.a. 1995-2007.

This productivity rise was the highest in the general UK economy which averaged 0.5-1% p.a.

Since the 1980’s, wages in finance have been the highest. Return on equity (ROE) in the UK from 1920-1970 hovered around 7% p.a. - much the same as other UK industry.

After 1970, ROE in UK finance trebled to 20% p.a.

Since 2000, banks in the US, UK, and Europe have consistently returned 20%+ ROE: more than double non-financial sectors.

Why are they so profitable? Why do banks get excess returns?

I introduced “risk” earlier because Andrew Haldane argues the cause of excess returns is the banks assuming higher risk.

Three particular strategies were used to boost risk and return before the crisis;
- increased leverage, on-and-off balance sheet,
- increased share of assets held at fair value,
- writing deep out-of-money options.

These measures were often hidden from regulators by cunning accounting.

The banks created the illusion that productivity increased their returns.

It was a mirage: a simple case of risk illusion by banks, investors and regulators.

I cannot give too much detail here for space reasons. But take balance sheets: banks traditionally used a capital ratio of 15-25%, but by the 1990’s it was 5%. Leverage rose from 4-6 times to about 20 times capital.

By 2007 major global banks were leveraged more than 50 times on average and this boosted their ROE.

Virtually all of the increases in ROE in UK banks are due to excessive leverage.

Moreover, the banks with the highest leverage made the biggest losses (write-downs).

Assets held at 'fair value' is jargon for trading (for example in shares) or in portfolio assets like securitised mortgages. These assets grew in market value until the crash in sub-primes etc. Those profits were an illusion too. Write downs in 2008 on structured products were US$210 bln.

'Out of money options' were when banks took on insurance in risky assets such as high-default loan portfolios, tranches of structured products, or writing insurance through credit default swap contracts. High risk won high premiums - hence the appeal of sub-prime, collateralised debt obligations (CDO).

Summary

Global banks appear to be exemplars of high productivity, and notable contributors to GDP. Statistical methods used in appraising their contribution are flawed: at a time when the banks were falling apart they were accredited with a massive performance.

They have been very profitable in the last 15 years or so, with an average rate of return on capital of 20% p.a.

This was thought to be the result of productivity, but it was because they took too much risk.

By about 2005, leverage was about 20 times their capital; just before the crisis it was often 50 times for major international banks.

Regulation is desperately needed.

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* Neville Bennett was a long-time Senior Lecturer in History at the University of Canterbury, where he taught since 1971. His focus is economic history and markets. He is also a columnist for the NBR.
neville@bennetteconomics.com
www.bennetteconomics.com