Is Bank of Ireland making too much profit?

Banks are not unlike utility companies - steady, perhaps slightly dull; businesses that provide a vital service. These firms should be largely invisible: what they do might be important but is not intrinsically interesting.

Soap operas based on the inner workings of a water or electricity company would not attract many viewers. Retail banking is hardly the stuff of a Hollywood blockbuster.

At least, that’s the theory.

As we know, banks have provided far too much excitement in recent years. But the utility analogy is still appropriate. Banks provide liquidity to the rest of the economy, without which it couldn’t function. Rather like water the underlying products are simple in the extreme: all pretty homogenous, straightforward and easy to understand, if sometimes difficult to get at and often expensive.

We only ever really get interested in utilities when something goes wrong. The plumbing infrastructure associated with water provision is very like that of the banking system. When sewers block up it can get both smelly and dangerous. When banks stop providing liquidity it is very harmful to the health of the economy.

Utilities rarely operate in a competitive environment. The capital costs of building and maintaining the necessary networks and infrastructure often make for natural monopolies or, in the jargon, oligopolies.

Competition is often introduced in limited ways - gas companies selling electricity and vice versa - but regulation also can extend to the size of profits these companies are allowed to earn. Different jurisdictions approach this issue in a variety of ways but a common method is to cap returns on capital. Sometimes this is expressed in terms of the cost of capital for a utility. So, for example, if the regulator deems that the cost of doing business for a gas supplier is 10 per cent it might impose a ceiling of 14 per cent on the returns on invested capital that can be earned. This in turn establishes a particular pricing structure: gas prices to the customer are set such that 14 per cent is the maximum return earned.

No method is foolproof or without controversy. But the point is that regulation acts to keep these businesses behaving within certain parameters and ensures, for the most part, that they stay boring. But the basic services keep flowing without interruption. Again, that’s the theory.

If we want banks to be as dull but as efficient as utilities they must be regulated in the same way. So one place to start would be with their return on capital. Banks boost their returns in two ways. First, they use leverage: this is what killed them during the bust. Second, they put their prices up: this is what they are doing now.

Leverage is like a utility pushing water under too much pressure down its pipes: sooner or later something is going to burst. Regulators are currently focussed, rightly, on trying to get banks to deleverage. Is enough attention being paid to underlying profits, the prices that banks charge their customers? Probably not. That’s because many banks, particularly in Europe, don’t have much pricing power so it isn’t a live issue. That may not be true in Ireland. The few banks that remain, can apparently charge what they like. This was seen yesterday with the Bank of Ireland’s announcement that its net interest margin is now 2 per cent. This is akin to a bank’s profit margin. It may not sound a lot but it is a margin being earned on rather large pots of cash.

Is 2 per cent evidence of normal or excess profits? The truth is that it is too early to tell but it is a number that needs close observation: as recently as the first half of 2012 it was as low as 1.2 per cent. So, underlying profitability has risen, a lot. According to Central Bank data, the last time BoI was as profitable, in margin terms, was in 2004 - testament to the leverage (rather than profit margins) that drove high earnings during the bubble years. If the number of banks operating in Ireland is an indicator of competitive pressures then we clearly have a problem.

As shareholders in the banks we want them to be as profitable as possible. As customers we want them to make enough money to stay in business, but no more. So we are horribly conflicted. That’s one reason why we should get out of being shareholders as quickly as possible. Then we can get start looking at banks in the same way as we look at sewers.