Bank lending and profits; a costly divergence
Don’t count on the profitability of the financial services sector as a leading indicator of anything. Well, anything other than financial services compensation.
A stupendous recovery in profits is underway at U.S. banks, brokerages and insurance companies, but the big picture shows that for the rest of us that rebound may prove sterile.
Data from the U.S. Bureau of Economic Analysis shows the sector had an absolutely cracking 2009, with profits rising in the fourth quarter by 240 percent against the same period a year before.
While overall corporate profits were up 30 percent the vast and less favoured parts of the economy outside of finance only managed to squeak out a 5.2 percent increase in profitability, and that came courtesy of an employment-savaging deflation in the costs of production.
In other words, the financial sector coined it as it benefited from cheap money, government insurance, and a steep yield curve while everybody else ate dry bread while squeezing more out of employees and holding wages down.
Financial profits in the fourth quarter are only about 8.0 percent below their 2005 peak and one-in-three dollars in profits went to the sector, which only represents about 16 percent of the corporate universe as measured by value added.
You might argue, so what? Banks are one of the main channels that carry the water of easy monetary policy to the rest of the economy, so it is natural for stimulative conditions to show their first flower in the sector.
There is something to that. There is a historical correlation between financial sector profits and an economic recovery.
Banks and other financial intermediaries help to finance the investment that leads an economy up and out of a trough and, so the thinking goes, where financial profits go the rest of the economy will follow.
Not this time, at least to judge by bank lending data. In 2009, while financial services profits were rebounding, total lending across the industry plunged, falling by 7.5 percent, the most since the World War II year 1942. Something on the order of $700 billion in credit has been extinguished, not including the huge loss of credit from the virtual shut down of the securitization market.
So it is hard to argue, at least on 2009 data, that the bailout of financial services was justified because it kept credit flowing. Banks kept record amounts of money in reserves parked with the Federal Reserve rather than putting them out to work as business or consumer lending. Banks chose to minimize new risks and simply profit from borrowing cheaply in short term markets and lending it back to the government for a longer period at higher rates.
Changes in accounting standards also gave banks good reason to commit capital to keep troubled existing clients afloat. This “extend and pretend” avoids having to take a hit to capital levels, though as we have seen in Japan it can have disastrous economy-wide repercussions.
A CHANGE IN 2010?
Banks of course don’t bear sole responsibility for lending numbers. Demand has been weak as borrowers concentrate on lowering leverage rather than preparing for new opportunities.
That tells us a lot about how the world works in a liquidity trap and with widespread and severe disinflation. It may also tell us something about how businesses and individuals view their own prospects.
Federal Reserve officials Elizabeth Duke and Thomas Hoenig have both sounded optimistic notes in the past week on bank lending in 2010, but Hoenig, speaking before lenders in Sante Fe, last week acknowledged that banks may struggle to lend while non-performing loans stay high.
The rebound in financial services profits has unquestionably done one thing very well and very discreetly. It has allowed the industry to begin to recapitalize itself without obvious recourse to the government, but still undoubtedly at a cost to the government and, essentially, in the form of a tax on the rest of the economy. It is a government-sponsored recapitalization that comes in the form of a subsidy rather than a direct transfer.
It could have been different. Rather than indiscriminately spreading profits to everybody and allowing a good percentage to walk out the door in the form of compensation, the government could have shut down large failing institutions in much the same way they deal with small banks, by firing management, selling what assets they can immediately and managing the rest until they can be sold or wound down.
Even if you take the bailout on its own logic, there is a real problem with a policy that results in the growth of financial services relative to the rest of the economy.
Financial services profits have grown by 600 percent from 1980 to 2009 while profits for everyone else have only doubled. During that period wages have stagnated and living standards have expanded via increasing debt, first private and now public.
It’s a funny way to run an economy.