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    Why do banks make such big profits?

    19 Feb 2024

    This is a common question when headline numbers are published.  It’s important to understand the context around those numbers.

     

    Financially stable and reliable banks play an important role in our economy by making money available that people can use to buy homes, start and expand their businesses, and trade with the world.

     

    They also give us a way forward when things like natural disasters strike or during an economic shock by directing lending to recovery and rebuild initiatives and supporting people through times of financial stress and hardship.

     

    Stable banks are less likely to go into default - which can avoid events like the European Debt Crisis, and result in recession, slowed economic growth, job losses, and social turmoil.

     

    But how much is too much when it comes to profit? And how do New Zealand banks’ profitability measures stack up, when comparing apples with apples?

     

    When banks release their yearly and half-yearly results, headlines often highlight the total profit in dollar terms – and they can be very large numbers.

     

    But behind those numbers are very large financial institutions.

     

    ANZ NZ is a large business with close to $200 billion of assets and $150 billion lent out to its customers across the 2023 financial year. To give a sense of just how large, if you combined Auckland Airport, Spark NZ and Infratil, their combined equity would still be less than ANZ NZ’s equity.

     

    The combined profit of those three companies for FY23 was $2.1 billion, ANZ NZ’s profit for FY23 was $2.2 billion.

     

    So, it stands to reason that ANZ’s size enables it to generate large profits, in dollar terms.

     

    A more accurate, and useful measure of profitability is to look at banks’ return on equity (ROE).

     

    ROE is one of the more common metrics used to compare the relative financial performance of different companies. All sorts of things impact a company’s ROE, including its revenue and how well it has managed its expenses.

     

    ROE is calculated by dividing a company’s net profit by the average amount of money shareholders have invested.

     

    In March of 2023, KPMG released a report which showed New Zealand banks had an average ROE of 13.4%, while the NZX companies had an average ROE of 15%.

     

    Using an ROE model is also a useful way to compare New Zealand banks with banks operating overseas in similar conditions, doing the same kinds of activities.

     

    In ANZ’s submission to the Commerce Commission on its Preliminary Issues Paper for the market study into personal banking services, a report commissioned from Incenta Economic Consulting was included, which looked at bank profitability.

     

    To provide a reliable benchmark, overseas banks included in the analysis were those that provide core banking services similar to those provided by New Zealand banks - like home and business loans, saving and term deposits.

     

    The analysis excluded banks from the European Union, the United Kingdon and Japan which have experienced deep-seated banking crises and have a materially higher probability of default.

     

    The report found that, when comparing New Zealand banks (including ANZ Bank NZ) to similar overseas banks, they had a similar ROE.

     

    Incenta’s analysis showed that ANZ Bank New Zealand’s average post-tax ROE, over the 2010 to 2021 period, was 12.3%.

     

    It examined the same period for similar international banks, and found their average ROE was “materially the same”, at 12.2%.

     

    "On this basis, ANZ believes that its profits – and the profits of New Zealand banks generally – are at a level that is consistent with there being a competitive banking market and are in line with profits earned by comparable international peers."

     

    On this basis, ANZ believes that its profits – and the profits of New Zealand banks generally – are at a level that is consistent with there being a competitive banking market and are in line with profits earned by comparable international peers.

     

    So, while it can be hard to comprehend how a single company can make billions of dollars per year in profit – the simple fact is scale plays an important role.

     

    Banks can be very large – and larger businesses can generate more profit, in absolute numbers.  Those profit figures are put into perspective when considering the overall return of a company compared to its shareholder investment.

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