Friday, 29 November 2013

More banking lies and propaganda

Three-quarters of today's editorial in City AM is good stuff, he points out that the UK government (and many others) is simultaneously trying to encourage and discourage reckless lending/banking.

But he spoils it with this:

The result, as Sir Andrew Large explains brilliantly in his report on RBS published on Monday, lending to small and medium sized enterprises (SMEs), which tends to generate a return on capital of between 3-7 per cent, comes with a cost of capital that is often around 11-13 per cent.

Banks do not have a "cost of capital" of 11-13%, that is the targetted or expected return on share capital, as narrowly defined. These idiots cannot tell the difference between a "cost" and a "profit share" and they are not comparing like-with-like.

For example:

A bank has made loans of £100, on which it charges 5% interest and has 1% running costs, so the income available to pay to depositors and shareholders is £4.

This bank is funded by £90 deposits, on which it pays 3% interest = £2.70, and £10 share capital/shareholders' funds.

£5 interest income less £1 running costs less £2.70 paid to depositors = £1.30 net profit for the bank/its shareholders.

£1.30 divided by £10 shareholders' funds = 13%.

So the bank is perfectly happy making loans at 5% and making 13% profits for its shareholders. That 13% is not a "cost" it is a "return".


Lola said...

And FYI the average return on the FTSE all share since the War has been ......ta da .....12.1%

Mark Wadsworth said...

L, thanks, yes, that is what we would expect, that the price of buying into any one of various monopolies averages out to give much the same return.

Dinero said...

I agree that is an odd use of the phrase cost of capital.

But the return is not £1.30 divided by ten because more than 10 is set aside for the unsecured SME lending.

Of course they could do more SME lending if the would accept a lower return.

and I agree that is an odd use of the phrase cost of capital.

Mark Wadsworth said...

Din, no that £10 is not set aside for anything!!! You are confusing "assets" and "liabilities/ownership side"!!

Let's take a simple example.

A man owns a house worth £100.
He has a mortgage of £90 (a liability to the bank analogous to bank#'s liabiliy to depositors)
Therefore his "equity"/"share capital" is £10.

That £10 is not set aside for anything, it cannot be spent, it does not even really exist, it is merely a balancing figure and/or a method of calculating the man's net wealth.

Dinero said...

refering to the post, whatever number you have for the figure that you call share holder funds it has to be higher for higher risk loans to comply with the banking prudency rules

Mark Wadsworth said...

Din, OK, so let's say that the govt insists that banks which lend to business need £20 share capital for every £100 lent.

Now re-work the fag packet calculation, the return on share capital is now only 8%, and so the "cost" is also only 8%.

The total return to depositors+shareholders is unchanged at £4, it is just divvied up differently - the shares are now "safer" (£1 of shares bears the risk on £5 of loans instead of on £10 of loans) and so get a lower % return.

Dinero said...

They could do more SME lending without increasing risk by doing a rights issue and use the funds to provide the increased capital required for the SME loans.

Mark Wadsworth said...

Din, yes of course, but that is the last thing the bankers want to do, what they want is the highest gearing possible, because that gives the biggest share price fluctuations and hence the biggest bonuses.

Lola said...

You may like to know that the average return on the UK Smaller Company sector since the War has been about 16% - a 4% premium over the broad market, and that's because they are riskier. The same numbers apply to UK Value stocks - i.e. compound return about 16%.

Mind you if you strip out 'inflation' the broad market return is about 6%. So it looks to me like the 11 - 13 % Mark calculated is markets automatically compensating for 'inflation', as in the destruction of the value of money. Or to look at it the other way round, without inflation investors would be happy with a 6% return on equity.

Which, intriguingly, as far as I can fathom, is about what has been achieved since 1693 (the formation of the Bank of England) on equity.

There is a lesson here, but I am not sure what it is.