Big Amount Does Not Equal Big Profit

by Steven van Groningen on 29 March, 2012

I like sports and often keep track of my performance. The other day I participated in an event that took me 4:20 hours to finish. Is this good ?

Of course you wouldn’t be able to answer because you don’t know what the distance was and if I was biking or running (or rowing) and what the conditions were. The result needs to be related to the effort, in this case the distance covered and means used.

About Profit And Profitability

When measuring the financial result, the principle is the same. We can’t make any statements about success -profitability- until we know what the financial effort, the investment was. Stating that someone who makes a profit of a thousand makes more profit than someone who makes one hundred is like saying that a biker is faster than a runner. If in first case the investment was 10.000 and in the second case 1.000, the profitability is the same. No one would claim that the first investor did a better job or obtained a better results.

Still, when I read about profits, it is predominantly about the net amounts of the profits. Not a word about profitability. Politicians and university professors complain about the giant profits banks make. This does not apply to banks alone, last week I saw similar comments on the profits of Petrom, Romania’s largest company, in Ziarul Financiar. Already some time ago there was an article in the Ziarul Financiar about the profits of the Romanian Banking system over the last 7 years (2004 – 2010). Based on BNR numbers, the conclusion was that the net profit in the total banking system over this period was 3,5 billion EUR.

What Makes A Big Profit

In order to form an opinion on how big a profit this is in terms of return we need to do two things. First we need to relate the profit to the effort made in order to obtain it, namely the investment. This gives us the return on investment. Once we have this we can compare with benchmarks or the return of investment in other sectors.

Computing the return on investment of a bank is a simple exercise and the data can easily be found on the BNR website. If we look at this we can see that the average return on equity (capital) for the Romanian banking system over the same period was 7,5 percent. If we were to add the results for the year 2011 to the picture, the overall result would be even lower.

So, now that we know what the return was we can form an opinion on how successful an investment really  is. We could compare the outcome to the results in other sectors, telecom, cement, pharmaceuticals, oil and gas, retail. We could make a comparison to investments in other financial instruments. Would you put your money on a RON deposit for 5 years fixed at an interest of 7,5%?

Risk Is Important Too

The standard way of doing this is to compare against a “risk free” benchmark. Because investing in a bank is a long term commitment – you cannot just take the capital out after a year – we need to look at an alternative benchmark, the yield on government debt for a maturity of, say 5 years. Today this cannot really be considered to be totally risk free but a better benchmark doesn’t exist.

So, if the shareholder, instead of investing, say, 2 billion RON in a bank, had invested the same amount into treasury bonds, the “risk free” benchmark, his return over the same period would have been about 7,5 % Obviously, by investing in a bank, which carries a higher risk, he would like to see a higher return. So, despite the big number of 3,5 billion, it was not a very good investment if we look collectively at the sector. In reality some investors have been extremely successful and others have done poorly.

Conclusion

Whichever way we look at this, the conclusion is that 7,5% average return over 7 years in not very high, it is actually low. Still, shareholders in banks have decided to reinvest a major part of the obtained profit in the Romanian banks, showing a long term commitment. Of course there are big differences from bank to bank, meaning some are clearly more profitable than others -which is good, because if all banks were at about the same level op profitability and it would be low, then the environment would most likely be blamed. A few banks that show good profits demonstrate that the banks that are not successful have only themselves to blame.

By the way, the 4:20 was for running a marathon, so not very good, my personal best is 3:30.

 

{ 9 comments… read them below or add one }

Maria Ditu March 29, 2012 at 22:31

Comment removed

I did this because your are not the person you claim to be. If you don’t want to use your own name, your problem, but please don’t pretend to be someone else.

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SvG April 1, 2012 at 15:37

As mentioned I deleted the content of this message, because your are not the person you claim to be. If you don’t want to use your own name, your problem, but please don’t pretend to be someone else.

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jhuitz March 31, 2012 at 08:35

Quite right. What you are taking is a full picture, and at a high level. The fact is that a primative view of financial performance is embedded in Romania, and probably other place as well. It works it’s way up to a major newpaper and back down again.

Let me explain. I often hear that doing that deal, this deal means big “profitability”, from all levels. What is meant is revenue. Yield is never considered, less yet the logic of the underlying earning structure. I stop, that is not what profitability means… Frankly, I am not sure if this is not all a simple mistranslation or fundamental misunderstanding. But all evidence points to the latter. And if that weren’t enough, there is always the old market share debate to fall back on.

Best of luck on this windmill.

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Catalin.V April 4, 2012 at 22:40

I strongly believe that the Romanian banking system would be a lot more profitable it it wasn’t for the huge costs you have. If we would compare the interest rates and all “innovative” taxes that the bank clients are paying in Romania to the Western Europe, probably the Romanian system should be crazy profitable… But unfortunatelly the Romanian banking system is corrupt to the core:
– underqualified and overpaid personnel; i worked for few years in a very big bank, i have relatives and firends that worked/still working in other banks. Everywhere it’s the same story – if you know the right people you get a good career path and a fat sallary.If you don’t, well tough luck;
– very limited control of what dirty businesses are run inside the banks; I heard a lot of stories of loans which were granted when it was obvious that they will not be returned…. However these loans were to important people… The latest stories i heard 2 months ago from a bank auditor that was on a “mission” in Romania. He resigned after 2 weeks when his superriors asked him to take it easier… I have so many examples…
– On top of non-profitable business done on purpose and overpaid personnel, banks in Romania have huge operational costs, because honestly why anyone should care when money are pouring in.

And to conclude my grim note, I think banks make a lot of money in Romania. It’s enough to count the number of bank offices. They’re literally everywhere.

If banks want a bigger profit, they should do a little bit of spring cleaning. The results could be mindblowing.

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Alex V. April 9, 2012 at 18:29

This post made me think of the early 90s here in Canada. I was a university student during this time and distinctly recall the media attention to the irony of record profits for the ‘Big 5’ banks in Canada, while the people were losing their jobs. Interestingly enough, this current economic slowdown doesn’t have the same ‘bank-bashing’…maybe because banks themselves suffered this time around. Surely if they had ‘record profits’ these days (regardless of what the ROI on that profit was), the popular media would be all over the story. It’s amazing to me how banks seem to always be a target of scrutiny and criticism. People seem ignore the benefits of having a strong and dependable banking system. Great blog, I just discovered it today. Thank you for sharing your thoughts and time with the world!

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SvG April 9, 2012 at 22:20

Thanks for visiting and your comment Alex. Indeed there are times is is no fun being a banker, when you make money you are wrong, when you lose money you are wrong…

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Parmalat June 3, 2012 at 17:46

First of all allow me to have my doubts over the actual situation.

While the reported figures may be correct, I will have to remind you there are more dimensions to a company’s activity than meets the fiscal reports.

For example management or consultancy contracts signed with other companies registered in offshore jurisdictions are a well-known way of diminishing a company’s profit margin. And of course there are other ways, especially when we’re talking about banks.

I’m sure the banking sector in Romania could have happily operated in the same parameters with a declared 3.5 billion loss instead of a 3.5 billion gain as it appears today.

And secondly, there’s a Romanian saying: “cainele nu pleaca de la macelarie nici batut”.

There aren’t that many places in the world to invest capital in. Banks operate in Venezuela , Iran, Afghanistan etc… where there’s 1$ to be made in profit – someone will go for it.

So I doubt we should be crying on the shoulders of the Romanian private sector in general, let alone the Romanian banking sector…

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SvG October 27, 2012 at 21:26

Since tax rates are lower in Romania, banks would in that case have moved their profits from high tax jurisdictions to Romania and not the other way around.

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Boberschi Andrei Marian February 7, 2017 at 09:30

What do you think about the fact that clients are the most importat part of a financial sistem?

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