Monday, February 8, 2016

Understanding Bank Profits

Every 3 months we get to hear again about how Canada’s banks made billions of dollars in profits for the quarter. Most Canadians are disgusted by it all. But there are a few simple things we need to know to understand why banks behave as they do.

Suppose a normal person, call her Jen, comes into a large inheritance, say $500,000. Jen would likely use the money in some way to try to improve her life. If she’s near retirement, she might retire a little earlier. She might change to a more fulfilling job that pays less. Whatever she does, it will likely consume the money over time.

Few people like Jen would react by trying to find a way to get even more money the next year. We tend to carry this thinking over to banks. If banks made so much money this year, why don’t they give us a break on interest and fees? Why do they need even more money?

The answer is that almost all of those bank profits get paid out to the bank’s shareholders as dividends. And shareholders want more dividends every 3 months. In fact, they want those dividends to rise over time. Whatever the banks earned this year, their shareholders want more next year.

While a big windfall for Jen reduces some of the pressure in her life, big profits for banks just create pressure to earn even more next year. You’d think bankers would be doing high fives and taking a break after earning $10 billion in a year, but this just makes them desperate to find ways to earn $11 billion next year. And if they don’t, they’ll be seen as failures.

Does this mean we should feel sorry for the banks? Absolutely not. The most important takeaway is that it’s a waste of time to wait for banks to grow a heart. The never ending new fees, fee increases, and debt promotion isn’t meanness; it’s desperation.

The cost of delivering banking services just keeps dropping as technology keeps improving. This should translate into cheaper banking and much lower bank profits. So far, it hasn’t worked out this way for the average Canadian, but the pressure remains on the banks to keep profits rising.

My response to all this is to expect banks to try just about anything to extract more fees and interest from me and my family. But I plan to pay as little as possible.

19 comments:

  1. As a Bank Shareholder (the only single stock I still hold), I applaud their abilities to rake every last nickel out of every Canadian, however, as a consumer I am appalled, nee, outraged by their huge profits. I guess I am a little schizophrenic on this topic.

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    1. @Alan: I'm in the same boat. I own the Canadian banks through ETFs, but I have to pay their fees as a consumer.

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  2. Competition affects innovation and profits. Is there enough in banking?

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    1. @Promod: I don't think there is enough competition in banking. I think the big banks will likely keep buying up successful low-cost start-ups. But that will just encourage more of them to jump into the fray.

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  3. Perhaps the solution is to own bank shares to offset the increase in fees?

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    1. @FT: That's one answer. Another is what many people are already doing which is to jump to low-cost banking solutions. I think Tangerine, PC Bank, and now EQ are just the beginning of lower cost solutions.

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    2. I recall Tangerine is owned by BNS and PC is owned by CM. EQ is owned by Equitable Bank, a small outfit out of Montreal. They pay a small dividend I recall :)

      More competition is a good thing though although I'd argue a few small business owners do want to get gobbled up by a larger multinational company. The goal of many small businesses is to make money too.

      Mark

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  4. You could own bank stock but use a credit union. You can also go into your bank branch and try to set your own fee terms; it'll probably work, but most people don't try.

    Speaking of competition, a few years ago I did some serious inquiring into actually forming a new Canadian bank (yes, it's possible). The government and legal paperwork and requirements are absurdly monstrous and basically insurmountable. I'm thinking by design as to stymie any hopes of competition (during the 90's the Big Five pressured govt to create more regulations with the aim of make operations more difficult and expensive for small/independent investment/advisory firms -- aka the competition.)

    Funny how the insurance and bank articles are back-to-back. Not sure which one is worse for the consumer and best for the owner.

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    1. @SST: I find it disappointing that almost all political discussion of regulations treats them a though all regulations are the same. In reality, good regulations make things better for consumers and bad regulations make things worse. It's impossible to make sensible decisions without discussing the contents of regulations.

      I had no particular plan related to writing those articles back-to-back. Maybe I just had huge companies on my mind.

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    2. There are also regulations and compliances which effect only the corporation but not the consumer. "Housekeeping" type compliance rules which cause large expenses in small business (mostly labour), but which large multinational firms can very easily accommodate.

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    3. @SST: I would classify regulations that discourage competition as being very bad for consumers, even if the effect is indirect.

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  5. Every Canadian focused mutual fund, ETF or dividend long term investor has them in their holdings to help them retire. Isn't their continued success beneficial for just about anyone who holds these investments as part of their long term plans? Sometimes its like people always want things both ways. They want to hate the evil banks, but if they are paying you $100.00 a month in dividends one day and are fairly stable in value, you might actually appreciate them more then.

    I find being friendly with branch employees also tends to get you a big break in fees. You simply have to sit down for 10 minutes and ask. I pay 0 fees at TD, and get a free small safe deposit box. I do have some minimum requirements to meet, but I feel they are fair.

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    1. @Paul: Inefficiency is a net negative even though it has positive aspects. As a whole the dividends we get as Canadians don't make up for all the costs we pay. But those who benefit from the status quo may try to dispute this.

      Every passing year, branch employees have less and less discretion. Their main value to customers is that they know the rules reasonably well and can steer you to a better path if they like you. But they generally can't overrule the bank's rules that are enforced through software.

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  6. It is each bank's moral duty to generate the maximum amount of profit. The fees are high because there are high barriers to new entrants. This is to do with Canada being a relatively small and fractured market and consumer conservatism. Most people wouldn't change banks even if you pay them1000 bucks. Banks will keep generating profits and increasing fees as long as the moat is large.

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    1. @BHCh: It's true that banks will relentlessly seek to squeeze higher profits from their customers, but that doesn't mean customers have to cooperate. Some customers are set in their ways, but an increasing number are flocking to new banking entrants, like EQ.

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  7. "...an increasing number are flocking to new banking entrants, like EQ."

    But the same thing happened with ING Direct. And then Scotiabank eventually acquired them. How long before EQ gets gobbled up? So really, there is no escaping Big Bank.

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    1. @SST: The big banks can't keep doing this indefinitely. Every acquisition gets more entrepreneurs thinking about getting rich by starting an online bank and selling it to a big bank. Eventually the actual cost of offering banking services will win out and the big banks won't be able to create fees that have no relationship to their costs.

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  8. I'm less certain of this because there are few, if any, alternatives to banks -- esp. with things like savings and chequing accounts.

    Is your vision that banks will become more like utilities rather than fee-oriented businesses?

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    1. @SST: I don't have any particular vision for the current big banks. I don't expect them to change. Big changes come from new upstarts and not from existing players changing their stripes. I expect the huge margins in banking to keep attracting new players until margins become more reasonable. But I'm not holding my breath. These things take time.

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