When is a profit not a profit?

Most of us, whether or not we agree with Mr Micawber’s assertion that profit equals happiness, would recognise his description of the basic principle of profit and loss: “Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.”

But for the banking industry, profit has apparently become a rather more slippery concept. The recently published report of the Parliamentary Commission on Banking Standards criticised existing remuneration policies in Britain’s biggest banks for being too heavily reliant on ‘narrow measures of bank profitability’. The commissioners, according to their report, reserved ‘particular scepticism for return on equity’ as an index of profitability.

The notion that you can either take a narrow or a wide view of profitability is a luxury that those of us who work outside the financial sector can’t afford. For us, whether as individuals or as businesses, Mr Micawber’s definition of profit holds true.

So how is it that the profitability of a bank can be so subjective and difficult to pin down? And what do we really mean when we say the banks have taken too narrow a view of profitability?

The stock answers to these questions seem to vary somewhat depending on your point of view. Those who have a stake in defending the rarefied world of high finance and keeping it as much as possible away from the glare of public scrutiny, argue that finance is, by its nature, incredibly complex. Us mere mortals shouldn’t expect to ever be able to comprehend the nuances and the technical wizardry of how banks become, and then remain, profitable.

Those who are more inclined to be critical of the banks tend to blame chronic short-termism as the primary problem.

I don’t find either of these answers entirely satisfactory though. While there’s clearly some validity in them both – yes, banking is complex, and yes, bankers have tended to focus too much on short-term outcomes – I think they miss the fundamental issue at hand. As far as I can tell, the problem is not so much that bankers have prioritised short-term profits over long-term profits but that they have prioritised illusory profits over real profits. In any other business, a profit that’s here today and gone tomorrow isn’t called a profit. It’s called a mistake.

I’m reminded of the economist Jeremy Rifkin’s iconoclastic, and to my mind rather compelling, interpretation of the causes of the financial crash of 2008. Rifkin refers to finance (at least in the form it took through the 1990s and 2000s) as the ‘fictional’ economy. In his view, the crash had more to do with long-term macro-economic trends – declining productivity, the end of the era of prosperity based on the technologies of the second industrial revolution, and the depletion of global oil supplies that led to record energy prices in the run up to the fall of Lehman Brothers – than with a short-term asset bubble and subsequent housing market crash.

Finance was the ‘fictional’ economy because it was not actually creating wealth – it was re-packaging wealth created during the long post-war boom and creating a huge, highly leveraged market based entirely on credit and debt. And as it gradually sucked all the life-blood out of the real economy the financial world turned inwards and became more and more disconnected from the real economy (‘self-regarding’ as the Archbishop of Canterbury recently put it).

The eminent Keynes scholar Lord Skidelsky quoted the following statistic in a recent lecture at the St Paul’s Institute: in the years leading up to the crash, bank loans in the real economy increased by 50%, while they grew by 260% to the financial sector. In other words, banks were abandoning their traditional role as intermediaries between investors and companies and increasingly just lending to themselves/each other rather than to anyone else.

As Sharon Bowles and Damian Horton point out in their contribution to the New Economics Foundation’s pamphlet, Banking 2020: A Vision for the Future, the problem is not just that banks lending to one another means they are lending less to other companies; it’s that as the chain of intermediation between investors and companies becomes longer and more complex, it becomes increasingly difficult for anyone to know the true value of what they’re buying and selling.

So, it seems to me that the banking sector still has some pretty fundamental questions to address: do banks really create wealth and generate prosperity for anyone other than themselves? And if not, how can they get back to playing their traditional role as facilitators of investment in enterprise and serving the needs of the real economy?

And if, as some are suggesting (Baroness Kramer at a Demos Finance event earlier this week for example), banks are no longer best placed to serve their traditional role as the intermediaries between savers and borrowers due to the arrival of new crowd funding, peer-to-peer lending and community financing models, then that begs a yet more fundamental question: what are banks for?

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