Recession 2008 (Part II): Crisis is out there but some banks are still earnig a lot of money

If you are a continuous visitor of Forbes.com, you will not be surprised to see that its ranking page on world’s top ten companies is occupied as much of more than half by bank and financial institutions. More surprisingly, the page hardly sees the first position taken by the company other than banking sector. In today’s list, five are financial institutions followed by three oil companies, with HSBC Holdings, a UK-based bank, on the top. Despite the belief that the current economic turmoil throughout the world has impacted banking sector the most, the banking companies have still maintained the majority on the top ten list.

Why do banks remain on the top positions? The answer is pretty simple. While Forbes determines the rank based on several criteria, let’s look at the criteria from stand point of profit only. To make things simple, we assume that there is a bank engaged in collecting deposits and making loans out of these deposits and also doing other traditional banking activities such as money transfer, investment in government securities, etc.). Let’s say the bank has $10 billion deposits which it collected at the interest rates, on average, of 3 percent. Out of this $10 billion dollar deposits, $1 billion will go to central bank if 10 percent is cash reserve requirement (CRR), leaving $9 billion available for making loans. Customarily, this bank will make loans at higher rates than deposit rates, say average of 13 percent. Here the spread between savings and lending rates is 10 percent, which is believed to be a major contributing factor for the banks to generate profit. If operating costs are covered by bank’s traditional transactions other than ‘spread income’, this 10 percent, which is equivalent to $900 million turns out to be a net profits of this bank. This simple math can help us figure out how banks earn a lot of profits.

The adage ‘no risk no gain’ typically applies to banking business though. While banking business is profitable, it is riskier too. The prediction of simple math above applies only during normal times. Whenever financial crisis happens, it is the banking sector that suffers most. We have recently seen financial giant AIG’s demise, which is a blatant example of how much the financial institutions are vulnerable to crisis. The crisis comes from both deposit and lending sides. We have heard of frequent news on bank-runs which is a deposit side problem, in which banks’ deposits are withdrawn very quickly due to possibly a rumor that the bank is not performing well. This problem may lead banks to be bankrupt overnight. Increased non-performing loans, a problem associated with lending side on the other hand, damages banks’ assets, again leading to their possible bankruptcy. Currently, the deposit side problem appears to have quite contained, but the lending side problem as a result of increased foreclosures are dominant in the economy. Federal Reserve chairman Ben Bernanke has recently made a comment about such continually increasing damaging assets that could possibly lead to more bailouts for additional banks in the days ahead.

Would banks remain on the top positions forever? Most probably. The crisis does not remain forever. Even during the period of turmoil, they have secured this position; normal situation is as such a boon for them.