Thursday, February 11, 2010

What Makes The Banking Business Different From The Non-Financial Business?

A major business difference between banks and non-financial companies occurs at the Gross Margin (aka Gross Profit Margin) level. Gross Margin represents the difference between sale revenues and the cost of goods sold as a percent of the revenues. In banking, this measure is called the Net Interest Margin. It represents the difference between the average interest rate the bank receives on loans and the average interest rate the bank pays out for its deposits and other borrowed funds. Gross and net interest margins do not include other business expenses.

For the 3rd quarter of 2009, the Net Interest Margin for all banks in the US averaged 3.36 percent. See St. Louis Fed data and the following chart.

Source: St. Louis Fed

(Click chart to enlarge.)

In non-financial industries, a 40 percent or higher gross margin is common. (See Wikipedia Gross Margin).

The low margin in banking compared to non-financial industries leaves little room for recovery from management mistakes, makes banking a high volume, low profit business and pressures banks to use high leverage.

For example, suppose a bank lends a $100, the borrower defaults and the bank recovers $0 and is out the $100. Let us say the bank has a net interest margin of 3.33 percent. The bank needs to make 30 other loans that do not default just to make back the principal (equivalent to a $100 cost of the goods sold) it lost from the defaulting borrower.

Now let us look at a non-financial company, such as a retailer than has a 50 percent gross margin. The retailer is selling an item for twice as much as it costs. The retailer is selling an item that costs $50 for $100. Let us say that someone comes in to the store, takes the item and leaves without paying for it. Shoplifting an item is equivalent to a borrower who gets funds from a loan and does not pay it back to the lender bank.

If the retailer sells another item, it will make back the $50 it paid for that item and have $50 left to cover the expense to the item it lost.

Non-financial companies have an easier time recovering from bad business decisions that lead to losses than banks. A few sales in a non-banking business can quickly recoup losses made from unfortunate events or bad business decisions.

In banking, many successfully repaid loans (sales) are needed to recover from bad luck and poor management decisions.

The lower margins in banking pressure banks to create high volume businesses, which requires more funding and necessitates high leverage and loan securitizations. Additionally, the profit dynamics of the banking industry makes managements' business mistakes more likely to be devastating to the firm with a much lower chance of recovering from a mistake.

Unless reformers explicitly deal with the banking industry business pressures of low margins, high volume and high leverage, their proposals will fail and future banking crises will occur.

People that blame incentive compensation packages for making bankers want high volumes to get high bonuses are naïve and simplistic. Banks paid incentive compensation packages because banking is a high volume business. Similar logic pertains to loan securitization, which allows banks to increase their volume of lending business.

Business forces in banking created the needs for the common practices that many blame for the financial crisis and these same forces left bankers with little room to recover from mistakes.

Reforming and restructuring the banking industry by narrowing bank business opportunities, decreasing leverage, and restricting banker behavior based on symptoms and not causes, will do nothing to improve the banking industry environment in the US.

Exactly the opposite of many proposals, such as the Volcker Rule, are needed to improve and protect the banking industry. Banks need more avenues of high profit margin businesses, more ways to leverage funds to increase volume, and more ways to generate income, such as fee, trading and investment banking income that are not dependent on loan repayment. Additionally, banks need better ways to recoup their funds from defaulting loans and unfortunately, the President and his cabinet have done just the opposite.

As banks transition into business models that allow them to generate income in higher margin businesses, leverage will decrease, the risk of financial calamity will decrease, uses of incentive bonuses will decline and the likelihood of another financial crisis will diminish.

Based on what I have read and heard in the media so far, I am not hopeful that regulatory changes to the financial industry will occur that actually help prevent future crises.

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