The dark side of rising bank profits

August 12th, 2008

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On Monday, the financial press reported in Bendigo Adelaide Bank profit surges that

Bendigo and Adelaide Bank, Australia’s seventh-biggest lender by market value, reported a 40% rise in full-year net profit, but said financial markets remained a challenge.

That sounds like good news right? Well, we do not know enough about Adelaide Bank to give any informed comments. But for those who want to dig deeper, here is one factor you may want to think about.

First, how does a bank make money? As we explained in Banking for dummies,

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates.

One way to make more money is to increase lending. In order to do so, the bank may borrow more (from depositors, for example). But the problem with this is that this also increases the risk of default for the loans. Therefore, in an effort to increase profits, the bank may increase their loans by lowering their lending standards. In a booming economy, bad lending practices can be masked by rising asset prices (e.g. stocks, property) as the banks can easily recover the full amount of bad debts by selling the assets used as collaterals. But when the economy tip into a bust, unemployment will rise along with falling asset prices. That’s when bad lending practices will lead to trouble. If the bank is highly leveraged, bad debts can quickly lead to a more than proportionate hole in its balance sheet (see Effect of write-down on bank balance sheet).

Rising bank profits may sound nice, but watch out for its dark side. Some cynics reckon that it is in the interest of current bank CEO to raise profits, collect millions in payout and then pass the mess of future bad debt problems to the next CEO to handle.

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  • “At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates.”

    With fractional-reserve banking, presumably you can offer higher rates for depositors than you demand from creditors, as long as the latter don’t put it all on deposit.

  • “At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates.”

    With fractional-reserve banking, presumably you can offer higher rates for depositors than you demand from creditors, as long as the latter don’t put it all on deposit.

  • Pete

    Thanks for this postulating Ed – I was wondering myself how a bank could have such profits (prophets, ha) today.

    I had a suspicion that all these profits couldn’t have come from anywhere too safe – i mean, look at the banks they were competing against? If they are losing money, how is Bendigo doing so much better? Well my answer to that was that they probably have limited US subprime exposure…but that does not imply limited AUS subprime exposure

    Incidentally, could you please do an article (if you want to of course) that talks about the exchange rates effect on the value of Gold in Australia? See I would have thought that lower exchange rate would totally prop up the gold miners? But I expect other costs to rise for the miners too, such as energy.

  • Pete

    Thanks for this postulating Ed – I was wondering myself how a bank could have such profits (prophets, ha) today.

    I had a suspicion that all these profits couldn’t have come from anywhere too safe – i mean, look at the banks they were competing against? If they are losing money, how is Bendigo doing so much better? Well my answer to that was that they probably have limited US subprime exposure…but that does not imply limited AUS subprime exposure

    Incidentally, could you please do an article (if you want to of course) that talks about the exchange rates effect on the value of Gold in Australia? See I would have thought that lower exchange rate would totally prop up the gold miners? But I expect other costs to rise for the miners too, such as energy.

  • Hi Sackerson!

    With fractional-reserve banking, presumably you can offer higher rates for depositors than you demand from creditors, as long as the latter don?t put it all on deposit.

    Why do you say that? How does the math work out? Let’s say $100 is deposited at 10.1%. The bank then lend out $99 at 10% (keeping a reserve of 1%). At the end of the year, the bank will receive $9.90 while it has to pay $10.10 to the depositors.

    Hi Pete!

    See I would have thought that lower exchange rate would totally prop up the gold miners? But I expect other costs to rise for the miners too, such as energy.

    Yes, everything else being equal, falling AUD will increase the revenue for Aussie gold miners. But its energy costs will rise as well.

  • Hi Sackerson!

    With fractional-reserve banking, presumably you can offer higher rates for depositors than you demand from creditors, as long as the latter don?t put it all on deposit.

    Why do you say that? How does the math work out? Let’s say $100 is deposited at 10.1%. The bank then lend out $99 at 10% (keeping a reserve of 1%). At the end of the year, the bank will receive $9.90 while it has to pay $10.10 to the depositors.

    Hi Pete!

    See I would have thought that lower exchange rate would totally prop up the gold miners? But I expect other costs to rise for the miners too, such as energy.

    Yes, everything else being equal, falling AUD will increase the revenue for Aussie gold miners. But its energy costs will rise as well.

  • Zoo

    Texas ratio? I make it about 37%. If anyone comes up with a better figure, please post it.

  • Zoo

    Texas ratio? I make it about 37%. If anyone comes up with a better figure, please post it.

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