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.