Part 1 of this series laid out a bleak future for monetary policy and/or banks. As interest rates go down so do bank margins and there are limits on how far interest rates can be cut because eventually, they take bank margins below levels adequate to cover losses or even below levels adequate to covering operating costs.

If this is right ultra-low interest rates are non-stimulative because they stress the bank sector causing the bank sector to tighten (not loosen) lending. Monetary policy hits a wall of non-effectiveness and ultimately bank bail-outs.

This is essentially the Raoul Pal view of the world. He sees no policy way out of the next recession -particularly in Europe - because if you don't cut rates you are stuffed and if you do cut rates you blow up the banks and you are stuffed anyway.
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As I said at the end of the last post I am not sure it is always so simple and/or so bleak. That is because ultimately there are two drivers of margins a weak one (Central Bank policy) and a strong one (the competitive landscape the banks face).

In Europe, both of these are driving bank margins down for most but not all banks. But it doesn't need to be that way and more deft policy-makers have different options.

But to see why need to run you through a stylized history of banking margins.

Lloyds Bank as the best bank in the world

Just over twenty-one years ago The Economist wrote a glowing article about what was then a roll-up of British High Street banks. It was Lloyds TSB.

A glowing article about Lloyds seems peculiar now as the bank was bailed out in the crisis and has lurched from disaster to disaster ever since. But under the title of The Lloyds Money Machine the economist wrote the following:
 

... Lloyds TSB runs head-on into a problem that most other banks would envy: it simply earns too much money. By some estimates the bank is sitting on £3 billion more than it needs. It would gladly use this for acquisitions. But short of buying another big British bank and closing down hundreds of branches, which would almost certainly be blocked on competition grounds, it is difficult to imagine an acquisition that would be as profitable as Lloyds TSB's current business.

The bank had fat margins and was busy cutting costs. The article goes on:
 

Peter Ellwood, former boss of TSB and now group chief executive, believes that even without further acquisitions the bank can continue its impressive run by cutting more flab and by persuading its existing customers to buy more of its products. Costs have already been brought down to 52% of income, a low figure for such a large bank. Once Lloyds and TSB are allowed to merge, analysts at Dresdner Kleinwort Benson reckon, the bank could shut more than 800 branches without weakening its high-street coverage, thus saving up to £300m a year. Along with these savings will come proceeds from the sale of businesses that underperform. The bank is seeking to sell Black Horse, its estate-agency arm. Its small Latin American banking and consumer-finance network may follow.*

At the time Lloyds was the thirty-fifth biggest bank in the world by assets but the biggest by market capitalization. It was hyper-profitable and traded at a svelte seven times book.

And then it all went horribly wrong. The bank took only a decade to be nationalized.

What went wrong was the competition. At the time Lloyds revenue to risk-weighted assets was 8 percent. This was the highest number I have ever seen on a major bank anywhere.

These fat margins attracted competition mostly in the form of Northern Rock and Fred Goodwin's Royal Bank of Scotland behemoth. These guys never saw a loan they didn't want to undercut. Revenue to risk-weighted assets in British banks went down by 75 percent. If you do it as a percentage of assets revenue as a percentage of assets fell from over 5 to about 2.

The point of this is that this happened in a non-zero interest rate environment. Competition killed margins and excessive willingness to write loans meant that margins were destroyed just as credit losses ticked up. You can find a full set of Lloyds accounts from CapitalIQ downloaded here.

German (and Italian and Japanese) banking margins have been terrible as long as I have looked at banks. In both markets, there was strong competition and a shortage of borrowers (at least relatively). Also in Germany, there were aggressive Landesbanken who fulfilled the margin compressing role of RBS. It is kinda-nice when you fund yourself with a quasi German government guarantee. It is not nice to compete against someone who has a German government guarantee.

By contrast, the oligopoly banks of Australia and Canada have made lots of money with a good economy despite being breathtakingly stupid. In banking - as in other industries - you make money out of market structure as much as anything.

Before everyone stuffed around with the definition of risk-weighted assets I used to compare revenue to risk-weighted assets by country. These are still roughly right in terms of profitability,
 

• The thinnest margin banks in the world were Japanese with revenue to risk-weighted assets of about 1 percent.
• Then were the Germans and the Italians at about 2 percent
• The Americans were in the middle - between 4.5 and 5.5 percent with a single outlier - the most effective major bank at screwing their customers in America - and that was Wells Fargo. Wells Fargo was about 6 percent.
• Then there were the highly oligopolistic Canadians at 6-6.5 percent.
• Finally - the fattest margin banks in the world were Australians. And that was at 8 percent. 

Our friends at Lloyds went from 8 percent at the time of the article to something in the mid 2s now. The world wasn't quite turning Japanese - but maybe turning German.

But there are outliers - and some of them are surprising. The Irish Banks look in Ireland pretty darn profitable. The Scandinavian banks are alright too - despite (say) Swedish interest rates going negative before everyone else.

Even some French regional banks are okay.

And these banks are profitable even in a negative interest rate world.

Swedish banks faced negative rate early - and they came out kind of well.

If central bank policy is going to work the central bankers are going to need to learn from the banks that have maintained reasonable profitability in the face of negative rates. This may be the single most important lesson for central bankers in the next decade.

If I knew all the lessons I would tell you. I don't. I know several of the outlier banks but nailing down quite why they are outliers is hard. But I will look for you.

Till next time when I will have a look at the outlier-banks.

PS. Whilst for years I used revenue to risk-weighted assets as a measure of profitability it doesn't work that well anymore because of changes in the definition of a risk-weighted asset. For the next post, I just intend on using revenue to total assets. It tells the story well enough.

*For the record the (retrospective) silliness of that Peter Ellwood quote didn't seem to hurt him later in his career. He got his knighthood somewhat later.