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The Secret for Stellar Banking Profits

We all have become deeply accustomed to the fact that banks are among the most profitable companies. Many perceive the success of banking as something magic. In fact, it is based on a surprisingly simple trick.

Profitable banks as symbols for capitalism? Bank CEO’s as advocates for less government interventions? Oh, please...

Profitable banks as symbols for capitalism? Bank CEO’s as advocates for less government interventions? Oh, please… (Photo: jorgophotography)


Why is Apple among the most profitable companies on this planet? The answer is simple: Apple sells popular products. Some people might have difficulties to understand the religious zeal of Apple customers, but even Apple skeptics can easily understand why Apple is one of the most successful companies on this planet.


JP Morgan Chase also made it on the list of the 20 most profitable companies. The American bank made a $22 billion profit in 12 months and achieved almost $100 billion in revenues.


What is JP Morgan Chase’s secret to climb into this exclusive league?


Is it because JP Morgan Chase is a popular brand? No, as a bank, the company is not liked too much by people. Thanks to Facebook, we can even quantify how unpopular JP Morgan Chase is compared to Apple: Apple got 25 million likes, while JP Morgan Chase received a meagre 200’000 likes. Ironically, this number is even lower than the number of its employees.


Is JP Morgan Chase profitable because it is innovative or because it offers superior services and products? Again, JP Morgan Chase is a bank. It offers the same bank services as any other bank. I have never come across enthusiastic customers for JP Morgan Chase products and services. Have you?


JP Morgan Chase is not popular, and it does not sell popular products. So how does JP Morgan Chase manage to be one of the 20 most profitable companies of the entire world? How has it reached the prime league of our market economy?



A Gold mine of our time


The first place to find a clue for resolving the puzzle can be found in the financial report of JP Morgan Chase. One of the rather impressive numbers in there is the overall value of assets on the balance sheet: $2.45 trillion. The number looks even more impressive with all the zeros displayed:




It would take a U.S. household with a median income of $52’000 roughly 47 million years to earn this amount.


$2.45 trillion puts the previously impressive net profit of $22 billion into perspective. $22 billion in profits on a balance sheet of $2.45 trillion translates into a net return on total assets of less than 1%. Every dollar JP Morgan Chase invests yields a return of a single cent every year after subtracting all the costs. The net profit that seemed so impressive in absolute terms looks small in relation to the invested money.


Does this mean JP Morgan Chase is actually a failure as a for-profit-company? Do its shareholders have to suffer hardship because they do not get adequate returns? One important piece to assess the ability of JP Morgan to make its shareholders happy is still missing. Shareholders do not care about the return on assets. No, shareholders care about how much return on equity JP Morgan Chase can generate.


The financial report answers this question as well. For every dollar shareholders invest, JP Morgan Chase borrows another 9 dollars. In other words, 90% of the $2.45 trillion in assets are financed with debt. The overall amount shareholders invested is thus “only” $216 billion. The net profit of $22 billion therefore translates into a net return on equity of roughly 10%.


The return on equity is ten times higher than the return on assets. In these days where bank deposits pay 0% and 30-year treasury bills yield 3%, a 10% return is quite agreeable. 10% suggest that JP Morgan Chase is not a failure but rather a blessing for its shareholders.



A dual edged sword


These calculations clarify that JP Morgan Chase has an entirely different philosophy than Apple to generate profits. JP Morgan Chase does not have to build a popular brand, offer popular products, or be superior in any other way it is doing business. The secret of banking to achieve high profitability is to borrow an additional $9 for every dollar of shareholders invested to leverage the mediocre 1% net return on assets into a respectable 10% return on equity.


In contrast, Apple just borrows $1 for every $2 shareholders invested.


Are the managers of Apple not clever enough in financial matters? Should they get advice from bankers to learn about the blessings of leverage?


Not really, as leverage cuts both ways. It not only magnifies profits but also exacerbates losses. If JP Morgan Chase had a return on assets of -1% over the last 12 months, that is, if it had lost $22 billion, the shareholders would have lost 10% of the $216 billion they invested.


Furthermore, borrowing comes at a cost as lenders charge interest on loans. And lenders have nothing to gain from leverage. Their potential upside is capped to the interest and principal payments, and the likelihood that they suffer losses increases with leverage. As such, lenders will ask for higher interest payments if Apple increases its leverage, or they might even refuse to lend money altogether.


The increased risk for shareholders and the higher financing costs that come with leverage is the likely reason why Apple does not increase its leverage to JP Morganesque levels.



Some are more equal…


It seems like JP Morgan Chase has found a vaccine to become immune against the dark side of leverage. A quick look across the financial industry reveals that JP Morgan Chase is not alone. Many banks succeed in ramping up excessive leverage ratios of 10 or more. So are banks just more tolerant towards leverage than other companies?


Let us conduct a thought experiment to test this hypothesis. Imagine you are a small business owner and ask JP Morgan Chase for a loan of $500’000. The credit officer eventually asks you about how much of your own money is invested, on which you answer: “I have 10% or $50’000 of equity, more than enough to create a ‘fortress balance sheet’ for my business. This ratio is good enough for Jamie Dimon, so I suppose it is good enough for me”.


When the credit officer starts laughing out loud, you will realize that what is good enough for Jamie Dimon is not good enough for you. As a lender, banks have the same leverage aversion as every other lender.


In other words, JP Morgan Chase would not get a loan from JP Morgan Chase.


So let us have a closer look at JP Morgan Chase’s lenders to make sense of this puzzling fact. The main source JP Morgan Chase borrows funds from are depositors. If you have a bank account with JP Morgan Chase you are actually one of their lenders.


Although depositing money rather feels like letting the banks safekeeping it, a bank deposit is actually a loan. The bank is not obliged to put your money into a separate box and keep it safe there until you withdraw it again. It can use your money for any purpose it deems appropriate.


If you are a JP Morgan Chase depositor, ask yourself why you were never concerned about its huge leverage. Furthermore, you are obviously willing to lend them money without charging any interest. Do you believe Jamie Dimon is an exceptionally talented risk manager who can make the risks of leverage disappear?


Let’s face it, you never even thought about how capable Jamie is when you deposited money at JP Morgan Chase.


Depositors do not worry about the leverage of banks because banks enjoy guarantees from the government and the Federal Reserve. The Federal Deposit Insurance Company (FDIC) guarantees your deposited money, and the Federal Reserve System (FED) will help your bank with its money-printing powers through any difficulties it might encounter.


Deposit insurance and lender of last resort facilities are the reasons why no one cares about leverage when opening a bank deposit, that is, when lending money to a bank. Most do also not care if their bank engages in irresponsible lending, complex derivative trading strategies, or if it gets charged with another thirteen-billion dollar fine. Depositor’s money is safe, no matter what.


The government guarantee induced negligence of lenders allows JP Morgan Chase’s to ramp up leverage and borrow $9 for every $1 from shareholders at extremely low interest rates. Without the FED or the FDIC, lenders would quickly wake up, panic, and pull their money as fast as they could.



Preach water, drink wine


It is ironic: Banks are at the heart of capitalism, yet, banks defy its elementary principles. Banks are not only protected by federal institutions from failure because they are “too-big-to-fail”; their entire business model and profitability is based on ongoing government support. Any reintroduction of “free markets” into the financial sector would lead to widespread banking panics and would invalidate the current business model of banking.


So what is Jamie Dimon’s view on capitalism and free markets, given he is the CEO of a megabank that makes its money primarily with government backed leverage? The following quote sheds some light:


“I’ve gotten disturbed at some of the Democrats anti-business behavior, the attacks on work ethic and successful people”


Was he disturbed that democrats rescued tumbling banks from their own mistakes and that they provided generous subsidies for bank managers and shareholders at the expense of everyone else? No, his concerns were directed at attempts to limit the amount of risk and leverage JP Morgan Chase could take at the expense of taxpayers. He branded these as anti-american, supposedly devised by people who do not understand how banking works.



Broken private-public partnership


A company like Apple needs to constantly reinvent itself to survive. It has to innovate, maintain the popularity of its brand, and keep its cost under control to keep the competition at bay. Apple cannot rest, or it will be washed away by the forces of creative destruction inherent to free markets.


JP Morgan Chase stands above these forces. It only needs leverage to generate billions of profits for shareholders and “incentive” payments for bank managers in good times. The downsides of leverage in bad times are then shouldered by taxpayers. Successful banking is actually not very difficult to understand and execute.


Banking privatizes gains and socializes losses. Jamie Dimon is right in one thing: The current setup is unsatisfactory. But he looks at it the wrong way. We should not so much worry about the restraints imposed by banking regulation but about the unfair advantages granted by all-encompassing government guarantees that become very real during “systemic” crises.


As long as this broken private-public partnership of contemporary banking persists, we will continue to see plenty of disdained and tardy banks among the most profitable companies of this world. A prospect that should infuriate all of us, including free-market oriented souls.


Update: Please note that Professor Anat Admati, who is a longtime fighter against silly arguments in banking regulation, has written already back in 2013 that “[p]rudent banks would not lend to borrowers like themselves unless the risks were borne by someone else. But insured depositors, and creditors who expect to be paid by authorities if not by the bank, agree to lend to banks at attractive terms, allowing them to enjoy the upside of risks while others — you, the taxpayer — share the downside.” You find the original piece online on the page of the New York Times.


The Secret for Stellar Banking Profits | Econom..., 2015-08-28 03:52:25:
"[…] We all have become deeply accustomed to the fact that banks are among the most profitable companies. Many perceive the success of banking as something magic. In fact, it is based on a surprisingly simple trick.  […]".
admin, 2015-08-28 01:13:07:
"Thank you. Please check out our idea of the systemic solvency rule. I have seen some of your comments on narrow banking and limited purpose banking, so I am sure you'll find it very interesting. Cheers, Jonathan".
Ralph Musgrave, 2015-08-27 19:15:01:
"Great article.".

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