British banks have recently been so profitable that the U.K treasury actually commissioned an inquiry into this extraordinary profitability.  England’s HSBC Bank (HBC) for example, had a net profit margin of 31.85%. Compare that to J.P Morgan’s 15.53% net profit margin. Barclays Bank (BCS) and Lloyds Bank (LYG) of England are also extremely profitable with margins of 22.16% and 26.02%, respectively.

According to the study by Don Cruickshank, “Excess profits arise when prices are consistently above costs across the output of an economic market. These excess profits translate directly into excess profitability, measured as the rate of return on the capital employed in the production of those products and services. Thus an indicator of persistently high prices relative to costs is persistently earning a rate of profit which is higher than the cost of capital employed.”

There are also several other reasons why British banks are so profitable. Equity analyst Ganesh Rathnam says, “Arguably, size provides a huge competitive advantage in consolidated markets.

“Unlike the fragmented U.S. market, five banks dominate the U.K. Lloyds TSB, Barclays, HSBC Bank, Royal Bank of Scotland, and Halifax Bank of Scotland all control well over 80% of market share.

“Counterintuitively, net interest margins are about one percentage point lower than the average of U.S. banks. Deeper analysis suggests that while these banks don’t compete with each other on price, the net interest margins’ low level prevents new entrants from earning an economic profit while maintaining the incumbent banks’ high profitability.

“In other words, these dominant players seem to exercise their oligopoly powers tacitly to prevent new competition from breaking into their market.”

That means these banks have large economic moats to keep competition at bay — a feature that Warren Buffett always looks for in his investments. And when it comes to keeping the competition away, size again affects British banks.

The U.K. being a physically small country, all four of its banks have branches nearly everywhere in the country. This makes it easier for them increase a customer’s cost of switching banks.

According to Rathnam, “Banking infrastructure plays a big hand in shaping the competitive dynamics. Unlike the U.S. market, banks in the U.K. and Ireland have nationwide platforms.

“A customer switching cities or counties in the U.K. need not switch banks as would a customer of TCF Bank moving to San Francisco. Unsurprisingly, customer churn rates are in the low to middle single digits, and market-share figures tend to stay constant over time.

“In addition, all these banks have heavily invested in customer relationship management software that helps banks gain “wallet share,” industry speak for selling multiple products to a single retail customer. For example, an average Lloyds’ customer buys 2.5 out of a possible 7.5 retail products from Lloyds.”

In reality, there is nothing to be suspicious about bank profitability. If run well, it is simply a great business to be in. Especially in England. With high switching costs for customers, steady profitability and an extraordinary economic moat, banks can provide fabulous investor return in the long run.

Regards,

Sala Kannan
June 30, 2006

Penny Sleuth Contributor

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