Posts Tagged ‘profits’

Is a bank safe if it makes good profits?

Sunday, April 19th, 2009

The masses dislike the banks immensely. In Australia, we read news report that the banks’ profits were higher today compared to last year. The masses surmised that since their profits have increased, they must be doing well. In addition, some of those who are very optimistic about Australia’s banking sector will cite the increased profits as the basis to support their optimism.

So, just because a bank is making good (and rising) profits, does it mean it is safe? The short answer is “No!”

Remember what we said in Banking for dummies, we said that

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank?s liability but your asset. In accounting technicalities, your money goes into the bank?s balance sheet as an asset with a corresponding liability.

As we said earlier, a bank profits by taking a cut between its borrowing and lending interest rates. If it keeps too much deposit money in the ?vault,? it is money that is not put in productive use and thus, have a negative impact on its profits. On the other hand, lending money out entails risks of debt default.

Basically, all a bank has to do to increase its profits is to lend more money! This increase in profits is highly visible in the profit and loss statements. But what is much less visible is the increase in debt default risks of its loans. Typically, banks will guess how much of its loans will default or be delinquent and apportion a small fraction of them as an expense. But until debt defaults really happen, a guess is just a guess. If their guesses are wrong by a long shot, the result will be asset write-downs, which will result in unexpected losses.

Assuming that Australia is going to face a serious bout of debt deflation soon, we can imagine many of the banks’ guesses will be revealed as laughable underestimates. Even if the banks realise today that their guesses are way off from reality, we can imagine that they will be loathed to confess because that will imply huge profit downgrades.

The Australian government better warm up their monetary printing press to be ready for the activation of their bank deposit guarantees, just in case.