21 May, 2024

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Debate Over Profits Of Banks: Who Shares Them Ultimately?

By W A Wijewardena –

Dr. W.A Wijewardena

Suspected profit earnings by banks

A general perception among many is that banking and financial institutions earn their incomes by overcharging their customers. The announcements made by banks themselves from time to time have contributed to ingrain this perception in the minds of the public. It is not uncommon for banks, when their quarterly, half-yearly or annual financial accounts are released, to highlight what they believe to be an extraordinary financial performance through press conferences, press releases or interviews with journalists.

Such communications are normally reported in the press with catchy headlines to attract the attention of the readers. These communications are basically made for the consumption of shareholders, prospective investors and other stakeholders who have an interest in the banks. However, they also lead, as an unanticipated corollary, to form opinions in all and sundry on the super performance of banks in earning incomes and making profits in comparison to their own dismal achievements.

Banking profits when economies are in the ‘downswing’

Such comparative opinion formation does not lead to further inquiry, if the economy, and therefore, all the businesses and entrepreneurs, experience an upswing in the business cycle. Then, everyone would be making profits and the so-called super profits made by banks would be lost in the euphoria of profit making by all those in the non-financial sectors.

However, this would change when the economy moves to the downswing of the business cycle as Sri Lanka is experiencing today. In that case, other businesses and other entrepreneurs would start to experience difficulties in maintaining profits which they had made when the economy was on the other side of the business cycle. When they see that banks have made profits and such profits are significantly higher than what they have made in absolute numbers, it is inevitable for the public to form the opinion that such profits have been made by banks at the expense of those in other business enterprises.

Gross incomes of banks

This paper will attempt at throwing light on the issue of banks’ incomes and profits. It would first examine the genetics of the issue and then, examine the distribution of the gross income of banks. It would also attempt at discovering many banking practices that have contributed to this popular public opinion. Finally, a way out in the form of a summary and conclusions would be presented.

Genetics of bank profits

Banks are profit seeking institutions and, therefore, there is nothing wrong in their making profits. Profits help them to survive and grow in business in several ways, whereas losses would punish them severely. The main role which profits play in a bank could be identified as follows:

1. Profits, as they do in any other industry, help banks to expand business without having to depend on the fresh contributions to be made by equity holders. When profits are retained within the bank without distributing, the equity fund belonging to the shareholders would expand making banking business more profitable. Such retained profits enhance the capital base of banks, thereby helping them to meet expansion expenses, withstand temporary losses, protect depositors’ interest, and maintain proper debt-equity ratios.

2. In any banking firm, it is normal that some of its borrowers would become delinquent, bringing losses to the bank. The losses on account of such loan delinquency must be offset by profits earned elsewhere. As such, it is necessary for banks to make profits.

3. Profits help banks to build and maintain the confidence of equity holders. The loss of confidence by equity holders would result in bank’s shares falling in value in the market, equity holders in large numbers exiting the stock and the bank being unable to raise additional capital at appropriate prices in the market.

4. Profits are also necessary to help banks wade through the episodes of the erosion of the market value of their investments. A substantial part of the assets of any bank would be in the form of marketable investments and the prices of such investments often fluctuate in the market. When the prices fall, the resultant capital losses must be absorbed through profits made by banks in other areas of business.

5. Profits generate resources for banks to undertake projects that help them to achieve corporate social responsibility goals. These are outside the normal commercial operations of a bank and must be funded out of revenue earned elsewhere. In today’s environment, corporate social responsibility functions are an important engagement by banks striving to be an important partner of the community they work in.

6. Profits help banks to move into the global economy by building the confidence of would-be investors. With a good profit record, banks would get good ratings and make them acceptable to international investors.

If banks make losses, the punishments meted out to such banks would be severe. Their survival, expansion and growth would be seriously threatened by continuous losses they have made. Their capital would be eroded and, sometimes, would become negative, placing them at the receiving end of regulators and would-be investors. Hence, no bank would pursue a goal that makes profit making a secondary objective of the bank.

Scathing attacks on banks

While everyone accepts banks’ right to make profits, his or her main objection has basically been to the rupee value of profits they make. Large profits in absolute terms are normally viewed as synonymous with excessive interest rates, higher fees and commissions and wide interest margins. All these three perceived culprits are then translated into a general conception of banks’ exploitation of their customers.

At an extreme level, any profit made by a bank is considered as a gain they have made at the expense of the customers. The danger of both these views is that, whenever a bank makes profits, it is subject to the most scathing criticism by certain sections in the community.

Reverse exploitation of banks?

The community expects banks to make what they believe to be ‘small profits’. Yet, banks make profits which are sometimes ‘large’ and sometimes ‘not so large’ by the standards of the investors. Even in the financial services industry, there is a wide variation in the amounts of profits made by different banks. Some banks make extraordinarily superlative profits, some dismal amounts of profits and some others, losses.

Hence, if one goes by the diagnosis made by the community, the exploitation of customers by different banks is at different levels. One would then argue that there is reverse exploitation of banks by customers in the case of banks which make losses. This argument cannot possibly be true.

Ready availability of bank deposits

The objective of any investor who has invested his money is to maximise the return. This goal is true for investors who have invested their money in the equity, debentures, or deposits of banks. If there is an exit mechanism, investors in banks would certainly use that facility to quit a bank which is relatively less profitable to a bank which is more profitable. This happens in the share market when shareholders dispose of their shares in a particular bank and reinvest the proceeds in a more remunerative stock, not necessarily in a bank.

In the debt securities market, if there is no facility to sell the debentures in the secondary market because such debentures are not listed, the agitated investors wait impatiently till the maturity of debentures and shift the investment elsewhere. In the case of depositors, a normal occurrence has been the ‘lifting’ of the deposit either prematurely or once it matures and re-depositing in a more remunerative financial institution. The first two courses of action do not affect a bank’s cash flow and liquidity since they take place outside the bank. But the reinvestment of debenture proceeds, and depositing maturing deposits elsewhere directly affect a bank’s cash flow and liquidity. A bank with a liquidity crunch would not be able to function as a bank for long.

Maximising profits

So, making only small profits by banks, as expected by some sections of the community, does not augur well for a bank. It may pursue such an objective at its own peril. Hence, banks pursue a goal of maximising profits as their primary objective. Banks could do so without necessarily exploiting customers. The options available to banks in this respect are numerous: raising productivity, offering competitively superior services, making money through trading of securities or forex, retaining the customer base through value-added products, and building a higher competitive edge over rivals through improvement of quality. The enhancement of profits by banks through these measures is not immediately discernible to critics. Such critics appear to be influenced by large profit numbers and media headlines. The Sinhala vocalist Sanjeev Lonliyes in one of his spell-binding Amu songs has warned the music fans that they should not just make choices only by looking at the cover page of a book. Similarly, it is not appropriate to take on banks on the face value of their accounting statements without probing into details.

The double standards about interest rates

High interest rates have often been quoted as evidence of banks exploiting their customers. The criticism in this case is mainly advanced against the level of interest rates. However, the level of interest rates is determined outside the banking sphere. In fact, it is a variable given to banks by the external monetary policy environment. When the authorities adopt tight monetary policies to check inflationary tendencies, the level of interest rates ascends to a higher echelon to curtail the excessive nominal aggregate demand, the main culprit of inflation in an economy.

The objective of high interest rates is to make it costly for all users of aggregate demand, consumers, businesses, governments, and investors. Though such rate elevation would raise the costs of these parties in the short run, its long-term benefits are substantial by way of generating price stability and creating a conducive environment for businesses to plan for the long term.

By the same token, when the economy operates with reasonable price stability, as is the case in Sri Lanka today, the authorities would relax monetary policy driving the interest rates to a low level. Then, the bank customers would find the prevailing interest rates favourable to them, though it has not been brought about by banks. Hence, it is not fair to criticise banks when interest rates are high and credit them when rates are low.
High interest margins

The high interest margins, i.e., the difference between the average lending rate and average deposit rate of banks, are also often presented as evidence of banks’ exploiting their customers. Though there is not any benchmark interest margin to be followed by banks, the margin maintained by their peers in the home country as well as abroad is used to assess the appropriateness of the size of the margin adopted by a given bank. In developed countries where there are developed financial markets with a high degree of competition, the interest margin normally tends to be smaller. In many cases, it lies between 1 and 2 percent. However, in countries where financial markets are not competitive and efficient, the margin tends to be larger.

On top of that, the prevailing monetary policy stance, and the tax structure applicable to banks too affect the size of the margin. For instance, if the authorities have imposed a high statutory reserve requirement as a part of their tight monetary policy stance, the underlying cost of maintaining an idle asset would widen the margin. Similarly, taxes, whether they are passed onto customers or not, raise the overall cost to be borne by bank customers.

When they are passed on, the customers have a higher transaction cost; when they are not, the interest margin would widen, because the banks must bear such additional costs. Apart from these events, the interest margin may be widened due to the inefficient management of banks.

Some banks fail to have a proper human resource management policy and may have employed a large workforce reducing the labour productivity in the bank. In such cases, the high wage bill will be reflected in the form of a widened interest margin. Banks are responsible for raising interest margins on account of inefficiency, but it is being done not as a way of deliberately exploiting customers. It is indeed an inevitable corollary of built in inefficiency in the banks. Yet, customers must pay for such inefficiency by way of having to pay higher interest rates or accepting lower deposit rates.

Information asymmetry

Another area of concern by bank customers has been the non-interest charges collected by banks. The general perception of many is that banks levy exorbitant charges for their non-lending services. Since charges are not explicitly disclosed by banks, customers are unaware of the different rates charged by different banks.

As a result, when customers patronise a particular bank for these non-lending services, they are unable to negotiate for the best rate. The information asymmetry about the rates charged, i.e., banks know the rates whereas the customers are unaware of same, reduces bank customers to a vulnerable group. As a result, even though the rates may not be exorbitant, bank customers still suspect that they have been subject to an unfair deal by their banks.

The solution to this issue is the elimination of information asymmetry by getting banks to disclose rates on a voluntary basis. In this case, mandatory disclosure requirements are ineffective since banks do not have incentive to disclose information in full. Hence, it is important to engage the use of outside parties like the Application Programmer Interface or API developers to disclose such information online will be an effective method of resolving the issue of informational asymmetry. This is still an unexplored technological application in Sri Lanka, though it is a very prominent method is EU, UK and Singapore.

To be continued..

*The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at waw1949@gmail.com

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Latest comments

  • 1
    3

    I have very little tolerance for banks. They piss me off! My experience is that they live on the sweat and blood of their junior staff.

    • 0
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      I too had a bad experience, where promises were made while opening accounts which included Medical facilities, reimbursement of routine medical expenses up to a limit depending on the age, and holiday facilities depending on the amount of deposits, etc. These promises attract me to invest. But after a couple of years, all these were stopped under various pretexts. My appeal to restore these facilities fell on deaf years. Hence I brought this to the notice of the Financial Ombudsman for redress. But no remedy was forthcoming. The ombudsman seems to take the Bank’s side. This particular bank now even charges for issuing Savings Passbook. This bank has considerably increased its profits as per the profit and loss statement published but Lost its Heart. Further, the bank promised death benefits without mentioning the age limit at the time Foreign currency accounts were opened. Subsequently, they say one should die before a certain age to enjoy the facility.
      In fairness to the bank, I did enjoy certain facilities in the past.

      • 1
        0

        Kanapathy Varunan,
        I worked for a Bank. I am familiar with your story.
        Bank is easy business; No chance of a failure
        .
        There ought to be more regulations against banks. But Governments are silent on them; Because Banks provide employment to people. That keeps people quiet!

  • 0
    5

    “The Sinhala vocalist Sanjeev Lonliyes in one of his spell-binding Amu songs has warned the music fans that they should not just make choices only by looking at the cover page of a book.”
    .
    Interesting comparison, though the idea that some look at banks that make good profits with suspicion is alien to me, perhaps insurance companies but banks?
    .
    A couple of decades back there were quite a negative perception among many about insurance companies, not sure if that has changed now. Has never run into people who think banks that make bigger profits exploit their customers.
    .
    I always thought it’s a good thing for banks to make big profits. Because that is where your money is and them doing good means your money is safe.

  • 3
    0

    Great information, Dr. W.A Wijewardena.

    Seems that the profit profile of our banks is quite vast, ranging from losers to big winners. But our big banks are big winners I bet.

    Interest rates apart, how does our ever competent government ensures that there’s no collusion amongst banks to set high service fees and charges?

    • 5
      1

      “collusion amongst banks to set high service fees and charges?”
      Check with private hospitals about their administration charges for consultancy appointments, abut half the doctor’s fee, much against government recommendation

      • 1
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        SJ, sounds like quite the mugging!

    • 1
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      No positive interest on fixed deposits for Senior Citizens. They are under serious difficulties.

      • 0
        0

        Yes, Kanapathy Varunan,
        .
        I wouldn’t want to complain about getting only a quarter of the Rs 10,000/= allowance given to government servants from this month on. After all, we have the option of sitting at home, not bothering much about travelling and clothing.
        .
        But little consideration seems to be given both to Senior Citizen FDs and to vast numbers of people employed by the private sector in professions where bargaining would be difficult.
        .
        Ranil, the Dictator, is doing as he pleases; he is determined to contest the forthcoming Presidential Elections, to be conducted under his watch. It’s time that we began to ask what foreign observers there will be on hand to observe the conduct of the elections, and whether the UN Human Rights Commissioner, who did much to probe the atrocities committed by the Rajapaksas, is following closely the economic manipulations of Ranil.
        .
        Panini Edirisinhe of Bandarawela

  • 2
    1

    Banks all over the world face up to this allegation and I feel that is very unfair, although capitalism is not my forte, but I tend to think rationally. Banks make big profits because most banks are big in scale, so their profits are big too. However, that doesn’t mean their profits as a percentage of the capital they deploy are huge too. A more accurate measure of banks’ profitability is to look at their return on equity (ROE) which is calculated by dividing a company’s net profit by the average amount of money shareholders have invested.

    On the other hand, making good profits is particularly important to banks because the average Joe and Jane put their lifelong savings in banks assuming their money is safe. They don’t do that with a supermarket or a retailer. So, a bank has special responsibility to protect that chunk of money with prudent investment decisions. People want an assurance that their money is safe and one main scale they use to be comfortable is, a banks’ profit level. Joe and Jane don’t want to invest their money in a bank that makes a loss or 1% profit, do they? Banks do have to fulfill that wish, unlike most other companies in the stock exchange, be it Apple, Amazon, or Walmart. Cntd…

  • 2
    1

    Cntd….
    So, while it can be hard to comprehend how a single company can make billions of dollars per year in profits – the simple fact is to understand that the ‘scale’ plays an important role. Just go by the ROE, not the profit volume numbers! On an average scale throughout the world, banks make profits of an average 15-20% of their ROE and that’s a fact! Compare that with pharmaceutical companies which make three-digit percentages of profits annually!
    Banks can be very large, even connected to leading global players, so larger businesses can generate more profit, in absolute numbers. However, if those profit figures are put into perspective, the overall return of a company compared to its shareholder investment is no greater than an average profit earning business. On the other hand, solid, good profit-making banks are the pillars of any economy and any modern government, or its people cannot prosper without such a robust banking industry. Simple as that!

  • 0
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    Whilst the Rajapakses, the Wickremasinghes, and the Srisenas have been a curse to us, we are fortunate to have as reliable and patient a guide as Dr. W.A Wijewardena, at this time when we have got thoroughly confused about the way our money seems to change in value on a daily basis.
    .
    And with Ranil being determined to actually get elected by the people, confusion for 22 million citizens seems set to get worse in the months ahead. But Wije, who responds to those who email him, is always there for us. Thank you!
    .
    Strange that the ten thousand rupee allowance being given to all government servants has hardly been commented upon. All pensioners have been given a quarter of that. I had expected those to come very close to the elections. Are these to end in December 2025?
    .
    This by a government that has kept saying that it has no money for elections.

    • 0
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      Continuation:
      .
      PART ONE of Three
      .
      All indications
      are that Ranil is going all out to get himself elected as President later this year so as to enjoy the power he exercises over us all.
      .
      Even he knows, I guess, that he is mortal, and so cannot hope to hold on until 2048, or whatever. But another five years, he thinks is possible.
      .
      To gull me into accepting him later this year, he has already increased the pensions of all who used to serve government by Rs 2,500. It may be that more is to come before October, only to dry up soon after he’s elected President. I don’t know what current government servants have got, but reports indicate that it is only 5,000/= for now, with the rest to follow before the Election is held. “Discontinuation” later need not mean stopping it. Effectively devaluing the currency will have the same effect. That much I know; I will not attempt to learn more Economics.
      .
      Tbc

    • 0
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      Continuation PART TWO of Three
      .
      Even for Ranil, there is a question of sustainability. He knows that he cannot possibly continue to allow us contentment, if he is to enjoy his power, for which we would all have paid. All efforts for now will be to persuade us to vote for him. Our short-term goal has to be to prevent that.
      .
      Why does anybody want to be a leader? That is too difficult to answer here, but clearly such a person ought to serve his/her entire community. Instead of that, we have here a man who wants the power that goes with being leader, not to serve, but to selfishly enjoy life. To that end, he is willing to sell us all into servitude.
      .
      I am firmly of the view that those who lead the NPP realise that there has to be justice and fair-play. None of them wants to be in power for ever and ever. It is now their task to instil the wisdom of such an attitude into all their supporters, and thereafter to all of society.
      .
      Tbc

    • 0
      0

      Continuation PART THREE
      .
      I will never know what the purpose of life existing on this earth is. One form of life appears to prey upon another. All that we know is that life-forms flourish for some time, and then die. Let as many life forms as possible flourish and be happy.
      .
      Is the purpose of all this is to serve God? The majority of those who say so, seem to be among the most ruthless exploiters. Therefore, that argument cannot be accepted.
      .
      No life form, including us humans, will survive death. To live and to be reasonably happy is an end in itself.
      .
      In the short term, what we must do is clear; act as intelligently as possible, so as to get the NPP elected. Why not sit back and wait for others to do it? Well, I’m not committing hara kiri.
      .
      https://en.wikipedia.org/wiki/Seppuku
      .
      That cannot be an end in itself. This line of thinking, I entered upon as a result of reading this article by Ravi Perera:
      .
      https://www.colombotelegraph.com/index.php/with-a-view-to-a-kill-master-spy-james-bond/
      .
      At least we do well to recognise that Ravi, AKD and Wije are decent people whom we value.
      .
      Panini Edirisinhe

    • 0
      1

      Sorry,
      .
      Please substitute “December 2024” for “December 2025.”
      .
      I meant to say that Ranil will cynically end his generosity the moment that he has won the Presidential Election.
      .
      We must prevent his winning. To which end, I shall vote One for AKD, and Three for Sajith. Why that Preference for Sajith.
      .
      Because there is always the possibility of Ranil succeeding in gulling sufficient voters to push AKD into third place (i.e. elimination) after a first round of voting in which nobody achieves 50%. That indicates the extent to which I regard Ranil as the greatest enemy who confronts us.
      .
      “If not AKD, then anybody else, except Ranil”, is going to be my strategy in voting. However, educating the Public cannot be a venture undertaken by any Political Party since it may end in many supporters inadvertently “spoiling” their ballots. However, this can, ought to be discussed here.

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