Retail banking versus retailing

Please allow me to comment on the letter to the editor from Mr K D Pillay, which you published in your issue of July 31, in which he said, in reference to the commercial banks:

“Even though Seychelles is a small market, the profit they are making is high.

This statement is based on the misconception of the nature of the business of commercial (deposit-taking) banks but certainly not on facts.

Unlike a retail shop, the profit margin of a bank cannot be readily ascertained as one can for a commodity such as a kilo of rice in a retail shop. For a retail shop, the key determinant of profitability is the turnover, in other words how many kilos of rice one can sell over a period of 12 calendar months for a given price.

To obtain the initial stock of rice, Mr Pillay has to rely either on his past fortune, a bank loan or credit from his supplier. The actual profitability of the shop is derived from the profit margin applied between the cost of acquiring a kilo of rice (or a multiple of other goods) and its retail price, multiplied by the number of kilos sold over the period.

This is the value generated by Mr Pillay’s enterprise, and in order for the enterprise to be profitable, that value must be sufficient to pay the running costs (salaries, electricity etc) of keeping his shop open. That profitability can be expressed as a percentage of total sales (turnover).

Commercial banks, however, operate with different yardsticks. The owners must first show proof they have R10,000,000 of their own money (not money they have borrowed) in order to obtain a licence to open an outlet. Secondly, they must show that they have the knowledge of the business or employ people who have, must seek approval as to where they can operate from, at what hours and must open at the hours permitted and be ready to shut their doors whenever the Central Bank tells them to.

Unless there is a state of emergency, Mr K D Pillay can keep his shop open all hours and is certainly not obliged to open his shop at the hours he does.

The product of banks is money – not the owners’ money, but that of members of the public (deposit). To obtain money from the public (entice deposits), banks must promise a number of things, eg convenience, security, returns (interest), as well as money (loans) etc.

To provide all these services a bank must spend its owner’s own money to create the premises to serve its customers, the skilled staff to deal with their needs, the cost of electricity etc and bear the risk of default on loans. 

The public deposits money with a bank on the understanding that it can have it back on demand, thus can deprive a bank of its main commodity at a moment’s notice. Hence, banks must lend depositors’ money not only securely but also carefully, and the Central Bank ensures they do that by regularly inspecting their books. Foreign exchange transactions are not strictly speaking a banking business, despite what the Central Bank Act says about money changing.

Once a bank receives a deposit from a member of the public (customer) it must immediately give away 10% of that money to the Central Bank as cash reserves. Why? Because if a bank gets into trouble and does not have money readily available to give back to its demanding customers, it calls for help on the Central Bank – as a banker of last resort – which in turn delves into the pool of reserves.

On this 10% of deposits with the Central Bank, the bank earns only 1.75% in interest. But the bank has promised the depositor between 2% and 4% (as of July 23). Where will it find the difference?

Naturally it is by charging higher interest rates on the remaining 90% of the deposits. Those rates will depend in turn on the overall demand for loans and cost of maintaining premises, staff, electricity etc. In principle, the greater the demand for loans, the lower the interest rates for a given profitability, unless demand outstrips supply, in which case lending rates would rise.

The following table is derived from the published financial statements of the six licensed commercial banks for the year 2009, which makes interesting reading:

 

R

ratio to total deposit %

deposits from customers

       9,795,035,454

 

foreign currency deposits

       1,609,970,000

16.44

rupee deposits

       8,185,065,454

83.56

cash balances with CBS

       1,514,901,818

15.47

cash balances with other banks

       3,920,645,846

40.03

loans & advances

       2,916,199,353

29.77

securities & investments

       2,372,273,521

24.22

As can be seen from the table above, loans and advances account for only 30% of the total deposits, for which banks charge between 9% and 18%.  Another 24% of deposits are invested in government securities, which yield between 2% and 6% driven by the government’s desire to reduce interest rates across the board, while the 10% cash reserves yield 1.75%.
In other words, banks must earn 100% of their profits from 60% of their stock in trade (depositors’ money). It is also interesting to note that 16% of bank deposits are in foreign currencies, which limits the banks opportunity to lend to rupee earners because of the currency mismatch, an inherent risk. The Central Bank would not allow them to lend abroad, which in any event most of our banks are not geared for.
The next table shows the actual income, expenditure and profits of the six commercial banks for the year 2009:

profitability

R

ratio to total assets

total assets

    11,422,978,723

 

total income

          910,556,658

7.97

interest income

          714,879,734

6.26

non-interest income

          195,676,924

1.71

interest expense

          237,448,919

2.08

non-interest expense

          346,180,708

3.03

profit before tax

          278,816,586

2.44

profit for the year

          190,492,422

1.67


The profitability of a bank is measured in terms of a return on total assets, which in turn, are made up of loans to customers, owners’ capital, reserves, premises etc. Based on this yardstick for our six commercial banks, total income (“gross profit”) is 8% of total assets while expenses account for 5%. Net profit to shareholders is less than 2% of total assets. In comparison to many other business activities, returns can be quite meagre in the money lending business. Lower lending rates will come at the expense of increased service charges (the trade-off).

The large disparity between what the banks pay their customers on their deposits and the rates they charge for their lending (the spread) is not a typically Seychelles phenomenon and neither is it because we are “a small market”.

This feature of bank lending has been observed in all economies emerging from economic crises and is attributed to inefficiencies, under-development of the capital market (disintermediation) and lack of confidence in the economy.
Inefficiency is a supply-side problem, while lack of confidence in the economy is a demand problem. Disintermediation is a structural problem that prevents supply from satisfying demand in a timely manner (rigidity).

With competition, banks can tackle inefficiency, but confidence in the economy and disintermediation rest entirely with their principal critics – the government and the Central Bank.  The ball is, therefore, in their courts.

Paul Chow   

Sources: NATION 8-5-10