Despite its problems, the bank is on the up...
Earlier this morning Lloyds Banking Group (LSE: LLOY) issued a trading statement in respect of the first quarter of 2012. For once it made a profit, albeit a mere £2 million after tax, which works out to be just over 0p per share. Naturally, the bank isn't paying a dividend.
Lloyds' shares have been an awful investment in the last few years, but these results show that there is a chink of light at the end of the tunnel. It's often the case that when an economy eventually recovers from a lengthy downturn, its banks' profits rebound quite spectacularly. Long-suffering Lloyds' shareholders will be hoping that this will happen sooner rather than later.
£1.5 billion. Really?
Lloyds Banking Group was formed back in 2009 after Lloyds TSB was persuaded by the Treasury to buy HBOS; a decision that ranks on par with using a chainsaw to cut your toenails while blindfolded...
The sheer awfulness of HBOS' loan book has dogged the bank ever since, but if you'd only been looking at the headlines then you might think that Lloyds has been doing quite well. That's because it prefers to define profit on a "combined business basis", which ignores most of the bad stuff that the rest of us have to deal with.
This quarter's combined business basis "profit" turned out to be more than £1.5 billion before tax. Though after various adjustments, such as the £375 million provision for compensation payments in respect of claims against mis-sold payment protection insurance policies, this falls to £2 million of statutory profit after tax.
A business that can't be run by idiots
Peter Lynch says that investors should look for a business that's so good it can be run by an idiot, because one day it will be. Banking is not an idiot-proof business because a bank can easily be ruined if it makes too many bad loans relative to its capital base.
HBOS was a prime example of this, having encouraged reckless lending by basing the bonuses for some of its senior managers and directors upon the amount lent rather than the quality of the loans. Any idiot can lend money; the important thing is to get it back.
However, despite the best efforts of its former directors, Lloyds is still a constituent of the FTSE 100 index. That said this is in large part because of a government bailout, and a massive rights issue in 2009 that means the British state now owns 41% of the company.
There but for the grace of God…
One British bank that has attracted a fair bit of praise in recent years because it didn't need a bailout is Barclays (LSE: BARC). But this had very little to do with the skill of its managers; instead, Barclays was lucky enough to be outbid for ABN AMRO in 2007 by a consortium lead by Royal Bank of Scotland (LSE: RBS).
ABN AMRO was an acquisition that was so bad that it made Lloyds' purchase of HBOS seem like a good piece of business. Had Barclays won the bidding war then it, not RBS, would have needed the mother of all bailouts, and Fred Goodwin would probably still be a knight.
The recent banking crisis was largely caused by faulty incentive schemes. Banks issued lots of share options to their senior directors, giving them all of the upside with none of the downside, thus encouraging them to make big bets with other people's money. They chose to make lots of risky loans and eventually ended up speculating in securitised mortgages, which had been taken out by people who couldn't repay them even in the good times.
Another thing that contributed to the banking crisis was the depositors' compensation scheme. This caused many people to chase the highest interest rates instead of depositing their money with the more secure banks. This guarantee was the main reason why so many people piled into the Icelandic banks and the British taxpayer ended up having to help bail them out in 2008.
How to fix the banks
Legendary US investor Warren Buffett has an excellent idea as to how to stop banks from getting into serious trouble. If any financial institution requires a bailout then its chief executive officer and their spouse (or partner) should be bankrupted. That should concentrate the mind wonderfully!
The risk of personal bankruptcy is a powerful incentive, and it's no surprise that the investment banks and private banks which remained as partnerships, where the partners' own money was at stake, didn't get caught up in the practices that led to the recent banking crisis.
Another alternative is to do what America did during the middle of the 19th century if a bank went bust. Back then every director was on the hook for several years' salary if their bank went under, while the shareholders had to pay the par value of their shares to the receiver.
One way to curb the banks' tendency towards reckless lending is to increase their capital requirements to prevent them from lending so much. A major cause of the credit crunch was that some banks were using leverage of over 30-to-1, so £1 billion of capital was used to back £30 billion of loans, which is way above the ratios used by most banks throughout history.
The future for Lloyds
As the trading statement shows, while things are improving, Lloyds Banking Group still has major problems, particularly regarding the payment protection insurance scandal where it routinely sold policies to people who were not allowed to claim against them!
That said, the market was fairly pleased, marking up Lloyds Banking Group's shares in early trading by over 2% in early trading.
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> Tony owns shares in Lloyds Banking Group (it's a punt on the recovery!)