Profitable banks are fine as long as reforms are in place

An unusually self-aware analyst once admitted that you can stare at an investment bank’s accounts “until your eyes bleed” – but you would still be none the wiser. Such is the complexity of a typical Wall Street bank that it is often impossible to achieve a comprehensive understanding of the underlying financial position.

And even if we can unravel the complexity to get a snapshot of the standing of a bank today, that tells us nothing about where it will be tomorrow. Things can change quickly, particularly when the bank is exposed via derivatives to unexpected events. The way in which some financial institutions were caught out – and the hopelessness of the risk management techniques they employ – was recently highlighted, yet again, by a “low probability” event, this time the uncapping of the Swiss franc.

Irish banks are nothing like this. They do not display Goldman Sachs or JP Morgan-style complexities. Recent calls for an investigation into Irish bank mortgage pricing practices reveal the underlying difficulty some people still have in understanding just how simple a proposition our banks really are.

Profit margins

Take one measure of profit margins, the rough equivalent of the difference between the cost and the selling price of any product. For banks, this is the

net interest margin

: the difference between what a bank has to pay to borrow cash and what it charges when it makes a loan.

Twenty years ago, margins for AIB and Bank of Ireland were 3.5-4 per cent – a fat, juicy rate of profit. Banks didn’t have to lend a lot money to make decent money. But for almost the next two decades those margins fell. Simple arithmetic tells us that a decline in margins leads to lower profits. Money can be made either by selling a little at a wide margin or a lot at a low margin. Tesco versus Lidl.

The Irish banks’ equivalent of Lidl and Aldi was the arrival of British and European banks. Our banks reluctantly cut prices and margins, initially to maintain sales (lending) but ultimately as a method to boost their overall revenues.

Loan profitability

The comparison with retailing breaks down when we observe the explosion of the market for loans over much of the last decade. The retailers were never able to expand their market the way banks did. The market for food and soap powder is much more stable than the market for bank loans. Which is the heart of the problem.

As loan profitability declined, banks just made more loans. The usual checks and balances disappeared. On the supply side, the arrival of foreign banks and the euro meant that a whole new source of cash available for lending appeared. On the demand side, we were more than happy to take advantage of this available cash.

Banks have lots of controls designed to avoid all of this going too far. Every banker knows that higher volumes of lending risks lower quality – the chance of loans not being repaid. Regulators know that internal controls are often weakened at precisely the wrong moment and need to be reinforced.

People who borrow know that there has to be a limit, which, if breached, risks disaster. The mystery is why lenders, borrowers and regulators all simultaneously decided the old rules no longer applied.

A deeper understanding can only be achieved when we realise that few, if any lenders, borrowers or regulators thought they were doing anything wrong. Our search for blame assumes that motives were mostly malign. By contrast, only experts in behavioural psychology can really shed any light on why everyone genuinely believed that what they were doing made perfect sense.

Stable banks

Bank margins, helped by those variable rates that everyone complains about, have recently crept towards 2 per cent – up from their lows but still half of what they once were.

If we want banks to be stable and not to repeat the mistakes of the past, this should be welcomed. As owners of most of the banks, we have a vested interest in some semblance of profitability.

Of course, margins can be too high or too low: both need to be avoided. But the only entity that seems to understand all of this, the Central Bank, is either not consulted, ignored or sat on when it comes to reforms of mortgage finance.