Re: DANGEROUS CURRENTS

[Ed Weick]

Victor Milne:

>Royal Bank blamed weak stock markets and narrowing interest rate margins for
>third-quarter profits of $464 million that were unchanged from the prior
>three months. However, those earnings were 8 per cent higher than the 1997
>third quarter. [my emphasis] Analyst Nick Majendie said, "It will be tougher
>to increase earnings overall 10 per cent for the group, the growth rate set
>by analysts for the banks."
>Do you see the incredible assumption? Unlimited growth. At the ten per cent
>growth rate that banks want their profits would have to double every 7.2
>years. Even at a "mere" 8 per cent it would only take nine years.
>
>Any high school student who has been introduced to the concept of geometric
>progression should be able to understand that this is impossible in the real
>world. When I learned about geometric progression many years ago, it was
>introduced by a fable from ancient India.
>

snip

>
>The bank presidents and stockbrokers and currency speculators who demand an
>unending geometric progression of profits are all multi-millionaires. Their
>real physical wants were long ago satisfied. The latest status symbol among
>many of them is a $230,000 wrist watch that keeps time no better than a $30
>Timex.
>
>What drives them on?

 

I would not presume to deny some of the points you make.  Indeed people are greedy, perhaps bankers and speculators more so than ordinary folk.  And it certain that most people prefer bull markets to the kind of economic uncertainty that we are now faced with.  However, I do think that we have to be a little careful with numbers.  I've prepared a little table to illustrate.   I hope I can post it without it looking too confusing.

 

Profits are the difference between all revenues and all costs.  In the table, I've assumed that revenues are initially $10,000 (a very small and poor bank) and costs are $9,700 throughout the period depicted.  The bank starts out with a profit of $300 during the initial period.  Being a very well run bank, it is able to achieve its objective of increasing profits by 10% annually, so that, in agreement with what you have said, profits more than double.  However, while profits rise rapidly, revenues rise only very slowly, about 0.3% per year.  Costs, which best reflect the value of the earth's resources being used by the bank, do not rise at all.  This should not be considered unusual for a bank because it shouldn't cost that much more to negotiate a loan for a higher than a lower value, and simply making an entry for $2 million should not cost much more than an entry for $1.5 million.  In the case I've developed, therefore, the impact of the bank on the earth's dwindling resource base is zero, though I do recognize that costs could increase as revenues do.

 

				Increase in
				Revenue
	Revenues	Costs	Profits	%
0	10,000	9,700	300
1	10,030	9,700	330	0.30
2	10,063	9,700	363	0.33
3	10,099	9,700	399	0.36
4	10,139	9,700	439	0.40
5	10,183	9,700	483	0.43
6	10,231	9,700	531	0.47
7	10,285	9,700	585	0.52
8	10,343	9,700	643	0.57
9	10,407	9,700	707	0.62
10	10,478	9,700	778	0.68

 

 

My example is entirely hypothetical.  However, it does make that point that one needs to be careful about drawing conclusions without giving some careful thought to numbers.

 

The example does raise a few additional issues, however.  One concerns how the bank might increase its revenues at the rate shown.  It could do so in several ways.  If the economy was expanding rapidly, its credit providing operations would undoubtedly expand, and perhaps it could charge higher interest rates.  Please note, however, that the issue here is the economy calling on the bank, not the bank pushing the economy.  That is, if the bank is prudent and conservative, it will only lend when borrowers come to it with relatively safe requests for loans.

 

Another way my bank could increase its revenues is through increasing market share.  During recent years, banks have done so not so much at the expense of other banks but by moving into other financial markets - e.g. by taking over trust companies and by expanding into the mortgage business.  Yet a third way is attaching charges to a lot of things that banks used to do free.  And, as I'm sure you know, there has been some recent controversy around banks tying one kind of business to another - e.g. pressuring borrowers to do other types of business with a particular bank, such as moving their mortgages over.

 

However, you should note that at least some of the foregoing are "zero sum" in their overall economic effect.  There is only so much trust business out there.  If a bank goes into the trust business, it does so either by taking over trust companies or crowding them out.  If it is able to coerce people into transferring their mortgages, others lose those mortgages as investments.

 

I would also suggest that perpetual 10% per year expansion of profits is highly unlikely in any business, including banking.  Banking may have a run of ten percents for a time, but as we are now learning, good times do not last forever and even banks, traditionally the most prudent sector of the economy, can set some nasty traps for themselves.  Indeed, in some parts of the world not only have individual banks failed, but the whole banking system has become insolvent.

 

I would not go so far as to argue that the scenario depicted in my small example has no impact on the earth's limited resources.  It may have some.  However, I would suggest that the main problem it raises is one of income distribution.  If the economy is only growing at a non-inflationary rate of, say, 2%, profit growth at 10% indicates a rather large transfer of income to the bank's shareholders.  It would seem that something like this has in fact been happening.  You may have seen the reference to a recent study of income distribution in yesterday's Globe and Mail.  That study apparently found that the rich in Canada are getting richer and the poor poorer, which is nothing new to anyone who watches numbers.  The same thing is happening in the US.  And, as I've suggested in recent postings to this list, the same thing is happening globally between rich countries, where the really big banks are headquartered, and poor countries.  Where this is taking us is far from clear.

 

Please do not interpret this posting as implying that I like banks and am their friend.  Actually, I do about 97% of my banking at a cooperative, and avoid banks as much as I possibly can.  My only intent is to suggest that we slow down a bit and perhaps do some back of the envelope thinking before we draw conclusions.

 

Ed Weick